Zombie Bankhouse?

I admit, I really don’t know if any major U.S. banks are insolvent or if the banking system as a whole is insolvent. A few months ago, it seemed to be conventional wisdom, with few dissenters outside of Tim Geithner’s Treasury Department. But around the time of the Treasury’s “stress tests” of the largest banks on May 7, which incredibly nearly all of those banks passed, the stock market was once again smitten with the banks.  As John Authers of the Financial Times notes, the S&P 500 Financials Index rose 8.3% the next day, to 175.8, a level more than twice as high as their March low. Financial stock prices have since tumbled by about 14% to 151.5 (as of July 6), but they’re still 85% above their low. A healthier sign still is that credit default swap contracts for bank loans and bonds indicate that the market thinks bank credit is slightly less risky than it was two months ago. Are we out of the woods yet?

Doubtful. The banks still aren’t lending (business and consumer loans are down slightly, real estate loans are about the same), and they’re still sitting on vast piles of reserves ($688 billion, up from $2 billion a year ago). Possibly this is just a rational response to a recession and a general worsening of consumers and firms as credit risks, but it looks like a continuing credit crunch, in which even good credit risks can’t get loans, and it does not look like the behavior you’d expect from healthy banks.

James Kwak of Baseline Scenario is still skeptical about the banks’ overall health, and links to a short piece by Harvard Law School professor Lucian Bebchuk, who says the stress tests were about as difficult as, say, jumping over a fence two matchboxes high:

Bebchuk says the stress tests looked at potential losses only through 2010, whereas a great many of the banks’ toxic assets mature in 2011 or later. Thus the burning issue from last fall — toxic assets and possible insolvency, either now (if these assets are valued at their market value) or later (if these assets default in whole or in part) — is still with us. Bebchuk:

‘To get a good picture of banks’ financial health, estimating the value of their toxic assets is unavoidable. Regulators could encourage each bank to sell part of its toxic portfolio and extrapolate the portfolio’s value from the price obtained in such a sale, or they could attempt to estimate the portfolio’s value as well as they can on their own.

‘Either way, the true value of banks’ toxic assets must be estimated before concluding that banks are armed with sufficient capital to carry out their critical roles. The kind of stress tests that the US conducted, and that other countries are being urged to emulate – and the ability of banks to raise additional equity capital – cannot provide a basis for such a conclusion.’

It seems the Treasury Department, now that its plan for massively subsidized private purchases of banks’ toxic assets has been shelved, has adopted a strategy of “what you don’t know won’t hurt you.” The hope is that banks can raise so much capital and grow their assets to the point where those toxic assets won’t matter. It would be nice if that happened, but it seems to involve a lot of wishful thinking. Or do I mean magical thinking?

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