Democrats have been critical of Geithner’s performance in recent weeks as well, with Rep. Peter DeFazio (D-OR) also calling for him to resign. And according to the New York Post, as Geithner gets battered, “JPMorgan Chase CEO Jamie Dimon is emerging as a potential replacement”:

Sources tell The Post that a number of policy makers have begun mentioning Dimon as a successor to Geithner, whose standing in Washington has suffered…[Dimon] has achieved rock star status during the financial crisis, having navigated JPMorgan through the recession and being a go-to guy when Uncle Sam last year needed Wall Street’s help during the collapses of Bear Stearns and Washington Mutual.

The Post cites “people familiar with Dimon’s thinking” as saying he “would love to serve his country.” No source in the article was willing to go on the record though, so who knows what their motivation for floating Dimon’s name was. As Laura Tara LaCapra wrote at The Street, “[Dimon's] name has been tossed about speculatively — and at times jealously — by those in the industry for some time.”

But politically, if such a personnel switch did come to pass, it would strike me as odd. Geithner’s problem is that he is perceived as being too cozy with Wall Street, and is blamed for the dichotomy between Wall Street’s resurgence and Main Street’s continued time in the doldrums. The failure of the “bailout” to translate into wider recovery is, fairly or not, laid on his doorstep, with 42 percent of Americans saying that “has done a poor job handling the credit crisis and federal bailout programs.”

If that is the case, how would the problem be assuaged by plucking a CEO directly from Wall Street to take over? For his part, Dimon has been very careful to applaud efforts at regulatory reform (aside from panning the idea of a Consumer Financial Protection Agency), and even penned a Washington Post op-ed fully supporting a robust resolution authority for taking apart failed financial institutions. He is also supportive of efforts to help troubled homeowners receive mortgage modifications, telling investors who were bashing the administration’s effort to that “they should get over it.”

Dimon has also said that “tax cuts should go to lower paid citizens, not the wealthy.” But he does not support limits on bank size, and JP Morgan is part of a Wall Street trifecta (including Goldman Sachs and Morgan Stanley) that is on pace to pay out $30 billion in bonuses, an increase of 60 percent from last year.

So if the perception is that Geithner is coddling the banks, would that change with Dimon, as opposed to someone without ties to Wall Street? I’m not sure that case can be made. But on the plus side, Dimon hasn’t characterized anything that he’s done as “God’s work.”

While the idea that taxpayers shouldn’t have to foot the bill when a bank fails was widely agreed upon, the FTT proposal ran into a wave of opposition, including from U.S. Treasury Secretary Tim Geithner:

U.S. Treasury Secretary Timothy Geithner on Saturday firmly opposed a proposal by UK Prime Minister Gordon Brown for a global tax on financial transactions. “That’s not something we’re prepared to support,” Geithner said, speaking after meetings of Group of 20 finance ministers and central bank governors in Scotland Saturday. He added that it is an idea that has been around a long time and has received mixed results.

While I don’t think that revenue from an FTT should contribute to the bank failure fund — because that would cause all traders, instead of just systemically-risky banks, to foot the bill — Geithner should be open to looking at an FTT as a general revenue raiser, particularly as Wall Street rebounds to record profits while Main Street stays in the doldrums.

The FTT, in theory, would be a fee of a fraction of a percent imposed on all trades. Regular investors likely wouldn’t notice it at all, but it could raise significant revenue from firms like Goldman Sachs, who are consistently churning paper back and forth.

Consider that, before the economic crash, financial service companies accounted for 41 percent of all domestic corporate profits. And just more than one year after Wall Street’s collapse, they’re back to making 31.5 percent. As Felix Salmon wrote, “financial services companies are meant to be intermediaries, middlemen.” But instead, they’re netting a huge chunk of domestic profit all for themselves, casting serious doubt on whether their activities are actually providing any social benefit.

As Dean Baker, the most outspoken advocate of the FTT, wrote, “if a financial transactions tax reduces the volume of trading, and therefore the resources used by [the financial] sector, without harming the sector’s ability to allocate capital, then it will be making the sector more efficient and freeing up resources for more productive uses”:

This could potentially be a very large benefit from an FTT. If it reduced trading volume by 25 percent (the middle scenario in Pollin et al.), leading to a corresponding reduction in resource use, it would free up more than $60 billion a year in labor and capital for productive uses.

So the tax could raise some deficit-reducing revenue, while giving us a more efficient financial system. That’s something that Geithner should be willing to spend a few moments contemplating.

Besides an across-the-board increase, the plan stipulates that firms that are designated Tier 1 (essentially those that are “too-big-to-fail”) have even higher capital requirements than everyone else:

Tier 1 FHCs should be subject to substantially heightened capital requirements. The failure or financial distress of a Tier 1 FHC can inflict serious damage on many other financial firms and the broader financial system. As a result, Tier 1 FHCs should be subject to higher capital requirements than other firms in order to force them to internalize the costs of such potential spillover effects. Capital requirements for Tier 1 FHCs should be strict enough to be effective under extremely stressful economic and financial conditions.

These are smart steps (many of which were suggested by Elizabeth Warren’s Congressional Oversight Panel back in January). In particular, hitting the “too-big-to-fail” firms with higher requirements is a no-brainer, as it will both mitigate some of their competitive advantages and potentially bring down overall banker compensation. Treasury’s outline also includes a strict constraint on leverage (the use of debt to supplement investment) and an increased emphasis on higher quality forms of capital, both of which make sense.

But the most interesting bit of the plan is the idea to consistently alter capital requirements — and even accounting standards — as the business cycle moves. This would help to reduce the typically pro-cyclical actions that banks take during an economic downturn. Current static capital requirements “encourage banking firms to contract lending or shed assets during a credit crunch,” which only exacerbates the downturn, leading to further cutting back by the banks in a vicious cycle. Treasury’s proposal would change that, imposing higher requirements during boom times and easing the requirements during a downturn:

Efforts to reduce the procyclicality of the regulatory capital regime, or even introduce countercyclicality, have great appeal from a macro-prudential perspective. Moreover, such policies also would contribute to the narrower micro-prudential goal of making individual banking firms less likely to fail. Capital regulation that cushions the effects of adverse system-wide shocks would better enable banking firms to absorb losses and continue operating as going concerns.

As Kevin Drum put it, “we won’t know how serious Geithner is about this stuff until he rolls out the details. But at least he seems to be singing the right songs.” Indeed, in terms of principles, this plan is a good start. Of course, “the industry is unlikely to accept new rules without a fight,” so it will be up to Treasury to turn a good vision into actual rulemaking, over the objections of the banks themselves.

The banks, though, think Treasury Secretary Tim Geithner is expecting prices that are too high:

The Treasury has rejected the vast majority of valuation proposals from banks, saying the firms are undervaluing what the warrants are worth…J.P. Morgan Chase & Co. Chief Executive James Dimon raised the issue directly with Treasury Secretary Timothy Geithner, disagreeing with some of the valuation methods that the government was using to value the warrants.

There are two points to make here. The first is that I’m glad to see Geithner rejecting the banks’ initial offers. The system for selling back the warrants was designed in such a way that it almost guaranteed that the banks would lowball the price. If Geithner is truly telling the banks to take their offers and beat it, that’s an encouraging sign.

Second, this charge from the banks that Treasury is somehow overvaluing the warrants doesn’t hold much water. According to a report released today by the TARP’s Congressional Oversight Panel, Treasury has thus far sold warrants for 66 percent of their value. From the panel’s report:

Treasury has to date sold warrants only from smaller banks. In those sales, liquidity discounts are likely to be a major factor in a way that they are not likely to be for large publicly traded institutions. If, however, liquidity discounts or any other rationales are accepted as a reason for taking only 66 percent of market value for the full group of warrants Treasury holds, the shortfall to taxpayers could be as much as $2.7 billion.

JP Morgan has reportedly “waived its right to buy the warrants and will allow the Treasury to auction them in the public market.” This, in the end, is the best way for Treasury to dispose of the warrants, as it “has the benefit of stopping any speculation about whether Treasury has been too tough or too easy on the banks” and “permits the banks to bid for their own warrants — in direct competition with outsiders.” If the banks really think that Treasury is expecting too much, then they should all waive their buying rights and let Treasury put the warrants on the open market. Then we’d see whose valuation is right.

The anticipated value of warrants for 10 of the largest banks that repaid their Troubled Asset Relief Plan funds is $3.3 billion using the Treasury’s valuation process, compared with $3.82 billion with a more conventional method, Linus Wilson, a finance professor in Lafayette, Louisiana, said in an interview. Investors are debating whether taxpayers will be fairly compensated for the risk they took by providing rescue funds for the banking industry.

Treasury’s approach to offloading the warrants is to have each individual bank suggest a price for its warrants. Treasury can accept the bank’s offer, or reject it and propose its own price. If the bank then rejects Treasury’s proposal, three arbitrators decide the final price “based on an average of the appraisers.”

But since Treasury is using a lowball determination of the warrants’ value, and the banks “have a solid incentive to bid extremely low,” it’s almost certain that the average will favor the banks, at taxpayer expense. At DealBook, Steve Davidoff made some suggestions for how Treasury can fix this:

First, make the banks’ initial repurchase offer public. They should be subject to public inspection — and shaming — if they try and take advantage of the government. Second, the government should toll the strict time limitations on the proceedings to allow time for it to respond adequately. Finally, to avoid this issue altogether the government should sell as many of the warrants it can now on the open market, before a repurchase request is submitted.

Davidoff’s first point about transparency is important. This is a transaction with taxpayers that we are talking about here, not a private business deal. The more we know about how the banks are conducting themselves in this regard, the better. Hopefully, transparent offers will also keep Treasury honest, as the public will know if Treasury accepts too low a price.

In the end, I think Simon Johnson is correct in that “the only sensible way to dispose of these options is for Treasury to set a floor price, and then hold an auction that permits anyone to buy any part – e.g., people could submit sealed bids and the highest price wins.” (Felix Salmon suggested then giving the banks “the right to match the winning price, if they’re so inclined.”) This approach would both produce a fairer result and ensure that the banks don’t get one final shot in at taxpayers as they wriggle free from TARP.

[T]hat initiative — called the Public-Private Investment Program, or PPIP — has lost momentum. Big banks worried about having to sell at fire-sale prices while small banks feared they would be shut out. Potential buyers balked at the risk of doing business with the government, concerned that politicians might demonize them for making big profits. The program’s problems threaten to stymie efforts by struggling smaller banks, in particular, to clean up their balance sheets.

The PPIP, much discussed and debated upon its release, has definitely faded from view. But just because we’re successfully ignoring the toxic assets doesn’t mean that the problem has gone away.

In fact, today, the Bank for International Settlements (BIS) — which The Guardian calls “one of the few bodies consistently sounding the alarm about the build-up of risky financial assets and under-capitalised banks in the run-up to the credit crisis” — warned that “taxpayers around the world still face potentially large losses because governments have failed to act quickly enough to remove toxic assets from the balance sheets of key banks.” And the BIS’ prime example is the U.S.:

Progress on problem assets has been slowed by the complexity of the securities affected, legal constraints and, above all, the limited political will to commit public funds to the clean-up effort. The lack of progress threatens to prolong the crisis and delay the recovery because a dysfunctional financial system reduces the ability of monetary and fiscal actions to stimulate the economy. The lack of progress on removing troubled assets from the banks’ balance sheets and recognising the associated losses is illustrated by the US experience.

Federal officials reportedly told the Journal that the “because a dozen or so big banks recently succeeded in raising capital,” there is less pressure to get the PPIP off the ground. But even if those few banks are healthy (and that’s a big if), what of every other institution, particularly small and mid-sized, grappling with toxic portfolios? The financial system is not repaired simply because Bank of America can raise capital.

For all the talk of “green shoots,” toxic assets and housing still seem to have bedeviled the administration, and unfortunately, those are two areas (along with rising gas prices) that can stop an economic recovery right in its tracks.

Treasury Secretary Tim Geithner and NEC Director Larry Summers

There has already been plenty of reaction to the piece, but I’ll turn it over to Simon Johnson, who takes on Geithner and Summers’ claim that “a few large institutions can put the entire system at risk,” so we need a systemic regulator:

You need to control the behavior of large institutions, more than a few of which got us into this mess. If you can’t come up with a proposal to prevent them from taking system-damaging risk (and there is nothing in today’s article about this), then break them up. The article mentions penalties for being large — higher capital and liquidity requirements for larger banks; we’ll see the details in/after Geithner’s speech tomorrow, but I am not holding my breath for anything meaningful.

Back in April, Nobel prize-winning economists Joseph Stiglitz and Robert Solow said that the “most disappointing” aspect of the administration’s regulation plan was that it didn’t fundamentally reorganize the way in which large financial firms operate, and I think that concern is still valid. It really depends on how stringent the capital and liquidity requirements end up being, but by counting too much on a systemic risk regulator and a new resolution authority (for taking apart large firms that go bust), the administration may not be doing enough to directly stop firms from becoming so large and interconnected that they threaten the system.

This is especially important since the plan seems to be leaning toward a “council” of regulators, loosely overseen by the Fed, that will monitor systemic risk. As Felix Salmon put it, “we need a powerful single regulator with teeth, not a council of bickering sub-regulators.” Indeed, we’ve already seen spats between the various agencies and their regulators, which, if they continue, will work to the advantage of the banks playing regulators off against each other.

I know it means stepping on the toes of some congressional committees and regulators themselves, but if the administration is serious about getting systemic risk under control, it needs to have both strict rules governing Wall Street and an enforcer that has enough power to ensure that the rules are followed. Hopefully, both of those will come to pass as the administration makes the extent of its plans clear.

As expected, the Fed announced that if banks want to free themselves of TARP, then they need to cut all of their other government lifelines, particularly proving that “they can raise money without relying on guarantees against losses provided by the Federal Deposit Insurance Corp.”

The Fed and Treasury plan to allow some banks out of TARP as early as next week. In an interview today with CNBC, Treasury Secretary Tim Geithner said that “I think I expect you’re going to see substantial repayments from some institutions relatively quickly.”

But Geithner also went a little further, and seemed to imply that TARP repayment means that the plan for removing toxic assets from the banks (the Public-Private Investment Program or PPIP) will fizzle:

“As confidence has improved a little bit, we may see less interest — both on the selling side and the buying side,” Geithner said. “It’s hard to tell, though, how much interest you’re going to see. There’s still some concerns, too, about the rules of the game.”

First things first, if there are concerns about the rules of the game, isn’t it Geithner’s job to clear them up? But more importantly, does this confirm that the PPIP is, as Yves Smith wrote, “dead on arrival.”

This has been a concern about the PPIP for a while, especially after the banks told Geithner in April that he deserved an A for effort, but they weren’t going to participate in the program. The banks have realized that the PPIP gives them no inventive to sell toxic assets at anything other than an inflated price. And since the stress tests showed that Treasury was willing to extend the banks guarantee after guarantee, they’ve (rightly, from their business standpoint) decided that the status quo is just fine.

But the assets are still there, aren’t they? Even if a firm like JP Morgan can live with them for the moment, what about Citigroup, where 44 percent of the assets are toxic? If PPIP is not the answer, then Treasury needs to find another one, lest Citi and others like it remain stuck as zombie institutions.

Now that banks are hustling to pay back their TARP money, Treasury has to decide what to do with the warrants, and the options are either selling them back to the original bank or selling them to third party investors. So far, only one bank — Old National Bancorp of Evansville, Indiana — has worked out a deal with Treasury for the warrants. And according to an analysis by Bloomberg News, if Old National turns out to be the model for all the other banks, taxpayers may be shortchanged billions:

Banks negotiating to reclaim stock warrants they granted in return for Troubled Asset Relief Program money may shortchange taxpayers by almost $10 billion if Treasury Secretary Timothy Geithner’s first sale sets the pace, data compiled by Bloomberg show….[Old National Bancorp.] gave the Treasury Department $1.2 million for warrants that may have been worth $5.81 million, according to the data. If Geithner makes the same deal for all companies in the rescue program, lenders may walk away with 80 percent of profits taxpayers might have claimed.

Goldman Sachs and JP Morgan are two of the banks leading the charge out of TARP, and reportedly “want to buy back the warrants and wriggle free of the government.” Linus Wilson, Assistant Professor of Finance at the University of Louisiana at Lafayette, has done the math and come up with what the warrants from these institutions are worth:

The U.S. Treasury holds 88.4 million of JP Morgan’s TARP warrants. These warrants on JPM are worth $20.20 each or about $1.79 billion according to my estimates. According to my estimates, taxpayers’ 12.2 million warrants on Goldman Sachs are currently worth $74.87 each or about $914 million dollars….Instead of JP Morgan and Goldman Sachs buying (or worse being given) the warrants from the Treasury, it is a better idea for the U.S. Treasury to sell those warrants to 3rd party investors.

In some ways, allowing the banks to purchase back the warrants at below-market prices would complete a sorry cycle, since Treasury (under former Secretary Henry Paulson) overpaid for the assets in the first place. But it seems like going the third party route best serves the taxpayers’ interest, which is what Treasury should ultimately be trying to do. As Sen. Jack Reed (D-RI) said, “taxpayers were there at a critical moment. They should enjoy the upside when these institutions recover.”

“The taxpayers ought to know that we are in effect receiving a subsidy. They put in 40pc of the money but get little of the equity upside,” said Mark Patterson, chairman of MatlinPatterson Advisers…Mr Patterson said it would be better for the US to bite the bullet as Britain has done, accepting that crippled lenders must be nationalised. “At least the British are not hiding the bail-out,” he said.

We’ve expressed concern before that, under the Geithner plan, taxpayers shoulder an disproportional amount of the risk while not seeing enough of the upside. And indeed, according to a “convoluted deal” agreed to earlier this year, MatlinPatterson has come to own 80 percent of the shares in Flagstar Bancorp of Michigan, while the US government “has ended up with under 10 percent.”

However, one interesting aspect of the announcement is how the government plans to help the banks raise the capital that they need. While the banks will presumably do their best to go out and raise capital from private investors, if they can’t, they will have the option of converting the shares that the government bought with the initial round of TARP into a new financial instrument:

This new instrument, called a “mandatory convertible preferred” share, gives banks the ability to create common equity as needed. The preferred shares convert to common shares when a bank or its regulator decides they should.

This means that the banks can convert government debt into equity if they hit a rough patch and the need arises. But as Robert Reich pointed out, “by this sleight-of-hand, the public takes on more risk,” moving from a preferred creditor to a common shareholder.

But more importantly, this whole song-and-dance means that the banks are still operating with a government guarantee, but without government control. They can go out and try to raise money, and investors know that the government is going to cover them if things go badly. The plan assures that the banks will remain alive, no matter how troubled, because Treasury will always swoop in to save the day. As James Kwak and Simon Johnson put it:

In the end, when a financial system is dominated by banks that are too big to fail – and they do fail – the only options are an FDIC-style takeover or the kind of public-private co-dependency that we see today. As far as the current crisis is concerned, the die is cast and the big banks won.

According to testimony delivered by Treasury Secretary Timothy Geithner on Wednesday, “the vast majority” of banks are well-capitalized. However, the stress tests are going to reveal the plight of the largest banks — which hold most of the assets in the U.S. — and thus are the ones to be concerned with. And if some preliminary analyses are any indication, things don’t look good.

According to analysts at Keefe, Bruyette & Woods (KBW) — which conducted its own stress test on 17 of the 19 banks that the government is examining — the U.S. banking system “might need as much as an additional $1 trillion in capital.” And as Bloomberg found, “bad assets at the biggest lenders almost tripled on average in the past year”:

Pittsburgh-based PNC Financial Services Group Inc. saw nonperforming assets — those no longer accruing interest — jump more than fivefold in the first quarter from a year earlier. They more than quadrupled at U.S. Bancorp in Minneapolis. At 13 of the largest U.S. banks, bad assets increased 169 percent on average from a year ago.

As Kevin Drum wrote “if [the KBW] report is even roughly accurate, I really have no idea how Tim Geithner is going to tap dance his way around the N-word much longer”:

If KBW is right — and their estimate certainly seems to be in the right ballpark — and a substantial fraction of that capital turns out to be needed by half a dozen of the biggest banks, where is it going to come from? The Times report is very antiseptic, but it’s a fantasy to think that any bank “on the verge” will be able to raise private capital, and the Treasury’s TARP money is nearly exhausted. So then what?

Indeed, Bloomberg concluded that banks “may have a hard time persuading investors to give them cash” due to the number of bad assets they hold, while there is increasing concern that Geithner’s plan for removing the assets will unceremoniously flop.

House Financial Services Chair Barney Frank (D-MA) also announced yesterday that “he no longer plans to expedite a bill that would allow the government to place large financial companies into receivership.” So we’re essentially left in no man’s land, with a growing number of assets, limited tools with which to combat them, and no political will to nationalize and break apart the very worst firms.

The prices being offered, they say, are simply too low, and neither massive government subsidies for buyers nor encouragement from President Obama has thus far been sufficient to change their minds. [...] [A]fter politely voicing support for the programs in principle, the bankers said that in practice, the prices for the toxic assets were still going to be too low when the programs are launched in coming months.

JP Morgan Chase CEO Jamie Dimon has confirmed that his bank has no intention of participating in Treasury Secretary Timothy Geithner’s plan for clearing away toxic assets. “We don’t need it. We have our own assets. If we want to sell them, we’ll sell them,” he said. “If we want to buy them, we’ll buy them.”

This highlights one of the problems with the Geithner plan: the banks don’t want to take a hit on the assets, and therefore are only willing to sell at an inflated price. But an inflated price means that taxpayers are getting the short end of the stick.

More importantly, though, it shows the trouble with the administration explicitly stating that all banks will pass their stress tests, while at the same time promising that taxpayers will provide “exceptional assistance” to a bank if necessary.

If nothing else, some miserable tests would have given regulators “ammunition” to “force banks to shore up their balance sheets by selling assets, even at prices lower than the bankers would like,” or have provided the justification for nationalizing a hopelessly insolvent bank. But with its chosen message, the administration has given the banks no incentive to sell their toxic assets for anything other than an inflated price, because they’re operating with what amounts to a government guarantee.

The International Monetary Fund has estimated that there are $3.1 trillion in U.S.-originated toxic assets stuck in the financial system. And as economics professor Sung Won Sohn pointed out, the failure to address the toxic asset problem in Japan contributed to that country’s lost economic decade, as banks kept bad loans on their books, preventing them from resuming normal lending.

So either taxpayers take a hit by overpaying for assets, the government simply pumps more capital into the banks, or we remain stuck with a zombie banking system. In each case, the banks will have won out over the public interest.

The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals. A structural framework confirm…s that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased. The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing.

In short, the toxic assets clogging up the banks are worthless, and not, as Geithner believes, stuck at a depressed value due to our lousy economic climate. This is a problem because Geithner’s entire bank rescue plan hinges on the notion that these assets are worth something. If that notion is wrong, then the plan will, at best, “simply fizzle,” and at worst, be a very expensive subsidy to savvy investors that does nothing to relieve banks of their toxic waste.

Like Nouriel Roubini, Coval, Stafford, and Jurek believe that “many major US banks are now legitimately insolvent.” Therefore, they write, “any taxpayer dollars allocated to supporting these [toxic asset] markets will simply transfer wealth to the current owners of these securities”:

To the extent that these assets reside in banks that are now insolvent, the owners are essentially the bondholders of these banks. The reason their bonds are currently trading far below par is that the assets backing up their claim are just not worth enough (nor expected to become worth enough when their bonds mature) to repay them. And so while they will be cheered by any government overpayment for the toxic assets backing up their claims, their happiness will be at the taxpayer’s expense since, to the extent that current prices are fair, they will be receiving more than fair value for their investments.

As more and more holes get blown in Geithner’s plan — and more banks evince a willingness to twist the bank rescue on its head — one wonders if nationalization is getting any more consideration.

With that in mind, it’s worth asking just how stressful these stress tests are, and whether they’re really going to show us anything about the banks that we didn’t already know. First, here’s what the tests entail:

Regulators designed the stress tests to ensure that banks could survive — and continue lending — even if the unemployment rate were to rise above 10% and home prices to fall by an additional 25%. The tests, which were conducted largely by economists and experts using mathematical models, seek to determine whether a bank would need more capital to continue lending under such circumstances.

Considering that unemployment is currently at 8.5 percent, and Moody’s Economy.com has predicted that home prices in some areas will fall by nearly 18 percent, the scenario laid out in the stress test seems pretty plausible, and not at all a worst-case scenario. There is also a “delayed time bomb” sitting in the housing market, as Alt-A (one notch above sub-prime) and Option-ARM “teaser” mortgages are poised to reset in 2009 and 2010, potentially wreaking further housing havoc.

Maybe that’s why William Black, a former senior bank regulator and S&L prosecutor, told Tech Ticker that the stress tests are “a complete sham” that don’t go far enough:

“There is no real purpose [of the stress test] other than to fool us. To make us chumps,” Black says. Noting policymakers have long stated the problem is a lack of confidence, Black says Treasury Secretary Tim Geithner is now essentially saying: “’If we lie and they believe us, all will be well.’ It’s Orwellian.”

As Dean Baker noted, “a stress test is supposed to examine a worse case scenario, not an optimistic one. By picking overly optimistic projections, Treasury increases the likelihood that banks will pass the stress test.”

The weakness of the stress tests may be further compounded by the recent decision to relax mark to market accounting rules, which could increase opacity and uncertainty about the value of toxic assets. If the banks are able to pretend that their assets are worth more than they really are, and the stress tests don’t push the banks to prove they can be solvent in the face of further economic deterioration, then as Felix Salmon noted, we may be “rubber-stamping utterly unrealistic [bank] balance sheets.” And that would be simply punting the problem down the road, while allowing zombie banks to continue lurching around the economy.

In my view you can apply the Geithner plans to the banks that are solvent, but illiquid and undercapitalized. But you can not apply them to banks that are insolvent. So first you have to do a stress test, and then figure out through a triage the banks that you should rescue and those you should take over. So I’m still of the view that some banks are going to have to be nationalized, and for them the plan does not apply.

Watch it:

As The Economist put it, “if America wants to avoid the fate of Japan in the 1990s…it is vital that its banks face reality“:

Done rigorously, the stress tests could force the banks to come clean about their balance-sheets and lead to the forced sale of assets into the government’s toxic-asset programme. If a bank cannot raise the capital to offset its losses, it should be deemed insolvent and temporarily nationalised. Mr Geithner’s proposal is part of a process that could lead to more certainty — even healing — in America’s banking system. But only if he has the gumption to turn his half-plan into a whole one.

Under the plan, the government and private investors will invest together to buy up between $500 billion and $1 trillion worth of real estate-related loans and securities from banks. The government will use up to $100 billion from the Troubled Assets Relief Program, matched by private funds, to capitalize the purchases.

With the plan, the administration is firmly wedded to the possibly faulty idea that the toxic assets are simply artificially depressed.

As Robert Waldman characterized it, “the key to the Treasury argument is that asset prices are far far below hold to maturity values and that no one wants to buy them — that is, that no one shops during fire sales.” There is also wide concern that investors — since they are subsidized by the government — will overpay for the assets, potentially exposing the taxpayer to losses which the investors can, for the most part, walk away from.

Now, Geithner’s plan may very well work (though Paul Krugman and many others seem firmly convinced that it will not). But there are also concerns that go beyond the simple effectiveness of the program. For one thing, as Matthew Yglesias pointed out, “under the administration’s plan the existing banks under existing management will go back into ‘normal’ business.” Will it be right back to the same old risky behavior?

Furthermore, this plan doesn’t change the fact that financial institutions will be too-big-to-fail. Regardless of whether or not Geithner’s plan works, systemic changes to the financial system need to be made. As Simon Johnson laid out:

If Secretary Geithner’s scheme works, we draw the lesson that our banks became too big and we aim to make them smaller relative to the economy moving forward. …We need simple caps on bank size, leverage relative to the economy and – this is harder – measures of interconnected tail risk (i.e., is everyone making the same kind of crazy loans?). Design a system with this in mind: regulators get captured and super-regulators get super-captured. If the scheme doesn’t work, we draw the exact same lesson.

So even if the plan goes off without a hitch, it can’t be the end of the line. And if the plan is a dud, “the cost will be continued vast over-capacity in banking, and a consequent weakening of the remaining, smaller, better- managed banks who didn’t participate in the garbage-loan frenzy.”

The goal of the plan is to leverage the dwindling resources of the Treasury Department’s bailout program with money from private investors to buy up as many of those toxic assets as possible and free the banks to resume more normal lending.

These details officially show that Geithner is hinging the rescue plan on the assumption that toxic assets have an inherent economic value and are not, as many analysts believe, relatively worthless. So, as Paul Krugman pointed out, “the zombie ideas have won“:

The Obama administration is now completely wedded to the idea that there’s nothing fundamentally wrong with the financial system — that what we’re facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.

As we’ve discussed before, if Geithner’s assumption is right, then the plan could work. However, if he is wrong — as many feel he is — then he is creating a situation in which investors can cherry-pick truly depressed assets and leave the rest of the junk behind, thus making a huge, government subsidized profit without fixing the problem.

Last week, we expressed some concern that Geithner’s plan is based on Goldman Sachs’ word that the assets are not relatively worthless, but are merely depressed by market conditions. At the hearing, Kashkari confirmed that private investors have given Geithner this impression:

Q: What kind of feedback are you getting from the private sector side? Are they buying into this approach that you’re floating out there?

Kashkari: They are. In fact, we had received inbound, unsolicited proposals from people in the private sector saying we have capital on the sidelines, we want to go after these assets. [...] By marrying government capital, taxpayer capital, with private sector capital and providing financing, you can enable those investors to then go after those assets at a price that makes sense for the investors and at a price that makes sense for the banks.

Listen:

These “unsolicited proposals” seem to be what Geithner based his plan on, as it revolves around the belief that, somewhere down the line, most toxic assets will be worth something. This is a tough concept to sell, considering that analysts feel the assets are truly worth, at best, 35-40 cents on the dollar, with a lot worth far less.

And if Geithner is wrong and most of the assets are relatively worthless, savvy investors will be able to cherry-pick good deals, while leaving most of the junk untouched. If they find a truly undervalued asset, they’ll go after it, while the rest of the assets will just sit. As Tim Duy noted, for Geithner, “there are no bad assets. Only misunderstood assets.” But if the assets are truly junk, then Geithner’s plan becomes an expensive gift to investors able to spot the few good deals amongst the garbage.

At Baseline Scenario, James Kwak wrote that the idea that many assets will naturally return to higher values is “wishful thinking of the kind that has hampered responses to this crisis from the beginning. They could; but they could just as well not.” And if they don’t, then taxpayers are stuck with the bill, while the investors get off scot-free.

The question becomes, when are you throwing good money after bad? When would it be better to take the bank over, break it up, sell it off, and better manage the bad assets versus just infusing it with capital? That to me is an option, call it what you like, that needs to be put on the table. [...] When the stress tests are administered and you can see that this bank is a zombie bank, I think there’s growing political will that we’re not going to keep throwing good money after bad.

Watch it:

Graham’s message echoes that of Kansas City Fed President Thomas Hoenig, who criticized the Treasury Department last week for nationalizing institutions in a “piecemeal” fashion. Like Graham, he called for taking over, breaking up and selling off “failed institutions that have proven to be too big or too complex to manage well.”

As Paul Krugman wrote, nationalization is a way to make it “politically and fiscally feasible to put in enough capital to revitalize the system.” Indeed, a new Newsweek poll found that 56 percent of Americans favor bank nationalization, but there’s no telling how long the public or lawmakers will stand for infusing funds over and over, while leaving the institutions under private control.

Treasury Secretary Timothy Geithner has said that nationalization is the “wrong strategy for the country,” instead devising a plan based on the potentially faulty theory that the toxic assets plaguing the banks are merely stuck at an “artificially depressed value.” But Graham is right in thinking that the stress tests will confirm the insolvency of some institutions, at which point Geithner’s plans will need a serious redesign.