The Baseline Scenario
Posted: 08 May 2009 03:23 AM PDT

There is nothing you can teach Wall Street titans regarding the timing of news flow.  Stephen Friedman, the former head of Goldman Sachs, resigned last night as chair of the New York Fed’s board, after committing essentially a rookie error.  In December/January, he traded the stock of a company (Goldman) overseen by the NY Fed, while helping to pick a new head of the Fed (formerly from Goldman), and presumably being aware of other potentially nonpublic information regarding bank rescues (benefiting Goldman both directly and indirectly).  The real error, given the Federal Reserve System’s incredibly lax rules on potential conflicts of interest at this level, was failing to disclose this information to the NY Fed – they learned it from WSJ reporters and that cannot have been a good moment.

If you have to resign, pick your time of day carefully, and Friedman is obviously advised by the best people in the business.  I’m looking at the hard copies of four newspapers.  The news of his departure does not make the front page of the NYT (not even the small stuff at the bottom) or the front page of their Business Day section.  There is nothing on the front page of the FT or Washington Post.  Even the WSJ only manages three paragraphs on the front page, before sending you to look for p.A10.  (It was on cnn.com from 5:55pm last night, together with his resignation letter.)

I haven’t checked who first broke the news, but Friedman’s resignation was of course the major development of yesterday.  The bank stress test results were hard-baked a long time ago, and almost all the icing on that cake had already been leaked.  But the stress test for bankers is still underway.

The idea of a stress test, of course, is to see what goes wrong under pressure.  We do this for banks with hypothetical scenarios, but when you go to see the cardiologist you need to step on a treadmill and actually get your heart rate up.  The stress test for bankers is very relevant for thinking about our future financial system in three ways:

1.       We are now seeing how they behaved during a boom, both in terms of compensation system and insider-type transactions.

2.      We can see what happened during a crash and attempted recovery; part of which is about massive taxpayer provided subsidies (do the bankers even have the manners to say thank you?) and much of which is about tilting the playing field towards pre-provision earnings (for which Jan Hatzius of Goldman has the most eloquent exposition).

3.      Most interesting, of course, is how bankers think.  They regard themselves as entitled to outsized compensation that encourages excessive risk taking.  They think that insider trading rules apply to other people.  And they are convinced that only they – and their friends – are capable of running government in boom or bust (or in ways that boom leads to bust, at which time you buy low and then recover through large implicit support from the government.)

Really what we have seen over the past two years (a great Freudian slip from the Comptroller of the Currency on NPR last night) is a stress test of our bankers.  If you think they basically did fine, then we can go about our business with essentially the same financial system that has developed in the last couple of decades.

If you have concerns about how they behaved and the potential consequences of such behavior down the road, then we need to talk further.  The banks passed their stress tests, in part because these were designed by bankers and people friendly to bankers (we could also think about how our regulators have done over the past two years).  But are the bankers passing their stress tests?

By Simon Johnson

Grading on a Curve
Posted: 07 May 2009 10:34 PM PDT

Mark Thoma has a great analogy for the stress tests. He picks up on this statement by Tim Geithner:

Some might argue that this testing was overly punitive, while others might claim it could understate the potential need for additional capital. The test designed by the Federal Reserve and the supervisors sought to strike the right balance.

Then this is Thoma:

I’ve given a lot of tests over the years, and I can pretty much make the mean on a test come out how I want through the design of the questions and how I score the answers. If I want a mean of 70, or around there, I can get it, and if a mean of 50 is the target, that’s possible too. . . .

If we choose a score of “70? as the dividing point between being solvent and being insolvent, then the percentage of banks passing the test is a function of the difficulty of the stress test: how the items on the balance sheets – the answers to the questions – are interpreted.

The whole thing is a fun read. I don’t think it’s a crucial point, but I like this part of the analogy:

Why did the government negotiate the outcome with banks and how lenient were they in those negotiations? There are always students who want to argue about the result of a test, to have sections regraded, and how you respond to attempts to “negotiate” a grade can affect the percentage passing the class, particularly when – as with the stress tests – there aren’t a lot of students/banks taking the test.

By James Kwak

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