Stress Tests: What We Don't Know and Won't Learn

Our government does not know how much has been lost in sub-prime mortgages, derivative instruments, and other bad debt. What is called for is a complete and independent audit of all the organizations being bailed out by taxpayer money. The independent auditors, appointed by the President or Congress, would examine the company’s accounts to judge their truth and correctness. They would scrutinize the amounts and sources of all their income, the amounts and purposes of all their expenses, the amounts and distribution of all their profits and losses. With this information, the government could realistically assess the damage to our economy and make realistic plans with realistic goals to alleviate the current crisis.

Instead of dealing with hard facts obtained by a rigorous audit, the Obama administration will work with information derived from a so-called "stress test", which is a computer program using economic models based on assumptions for the future. An economic model, according to the Dictionary for Business and Finance (John V. Terry, University of Arkansas Press, 2nd edition) is "The consideration of quantifiable factors which may be either variables or constants and the construction of relations among them that may be expressed in the form of an equation." That's business school language for, "If any activity can be measured, it can become part of an economic model."

Unfortunately, it is usually what cannot be measured that brings economic troubles: greed, arrogance, stupidity, political ambition—these cannot be measured, but they adversely affect our economy. Unforeseen and unpredictable events—hurricanes and tornadoes, droughts and floods—also directly affect jobs, industry, food production, and shipping, to name only a few economic activities.

To make things worse, the stress test will also include other predictive models created by the banks themselves. Those who survive the stress test—that is, those bankers who create models that show that their organization can survive—will receive government aid. Unfortunately, any MBA or graduate-school economics major can create an economic model that will show high profits and enormous growth in the future.

It is arrogance on the part of economists, bankers, brokers, and financial analysts that lead them to believe that they can predict economic activity through the use of models, and it was their economic models combined with greed, stupidity, as well as unforeseen and unpredictable events that put us into this mess.

Another reason for the need of a complete audit is the law prohibiting the regulation of derivatives, which are at the heart of the subprime mortgage crisis. The mortgages were bundled into single financial instruments, whose value was then divided further into other securities and sold to investors as security-swap or credit-swap agreements. The value of these agreements, also known as derivatives, were based on a model—another model!—of what the issuers thought the value would become.

Derivatives are not regulated by the SEC. In fact, the SEC is forbidden to regulate these chancy investments by the Gramm-Leach-Bliley Act of 1999. It states in part, that " the Commission is prohibited from registering, or requiring, recommending, or suggesting, the registration … of any security-based swap agreement." Also the SEC is prohibited from making, interpreting or enforcing rules "… as prophylactic measures against fraud, manipulation, or insider trading with respect to any security-based swap agreement."

Another result of the Gramm-Leach-Bliley Act was the repeal of the Glass-Steagall Act of 1933. Glass-Steagall prohibited commercial banks from acting as investment banks. Commercial banks could lend money, but they could not underwrite any stock or security. With the repeal, commercial banks took ownership of investment companies and began offering investments as well as savings accounts.

Banks’ profits from their customers’ investments grew faster than those from their customers’ savings accounts. They were affected during the Reagan administration by banks and by law. First, banks began to require minimum balances, usually in the thousands of dollars. If a young worker tried to accumulate a nest egg via his savings account, but had less than three thousand dollars, his account was charged a service fee, very often an amount equal to the modest addition that worker could make to his account. Thus, workers stopped saving, and banks increased their profits by paying little or no interest on savings accounts.

Second, almost simultaneously, laws were passed so that banks offered IRAs to their customers and corporations, 401Ks to their employees. Both involved investing in stocks or money market accounts. Conspiracy theorists, mysteriously, have yet to pick up on this coincidence, but IRAs and 401Ks increased banks’ profits and helped Wall Street recover from a decline that had begun during the Carter administration. Workers’ savings became dependent on their employers’ payroll departments.

All this leads me to believe that the Gramm-Leach-Bliley Act must be repealed as soon as possible and the Glass-Steagall Act, or its modern equivalent, be re-enacted. Part of this legislation must be the creation of an Auditor General who can check a corporation’s books and enforce the law. To those who protest because they are committed to small government, I respond by protesting the financial services industry’s fradulent behavior makes this kind of law necessary.

How did the banks, insurance companies, and other financial institutions get away with it for so long? Where did our money go? We may never know, because the financial services industry sponsored the re-election of almost all members of Congress, as well as the President and Vice President. See my blog about campaign finance "Of Time, Money, Elections and the Constitution," November 16, 2008. Few elected officials in Washington are pressing for a complete disclosure from their benefactors.

These benefactors have also helped the two men appointed by President Obama to oversee America’s economic recovery. Lawrence Summers and Timothy Geithner were involved in the very activities that put us into our current crisis. Frank Rich reported in The New York Times (12 April 2009) that Lawrence Summers had received over $5 million from D. E. Shaw, a hedge fund, and almost $3 million in speaking fees from Citigroup, Goldman Sachs, and other such institutions which have gotten money from the taxpayer bailout. Summers also tried, and failed, to have a co-founder of another hedge fund, Taconic Capital Advisers, appointed to the job of running the TARP bailouts. This was clearly a conflict of interest, because while president of Harvard, Summers had done consulting work for Taconic.

The other man responsible for creating our economic chaos is Secretary of the Treasury Timothy Geithner. Before President Obama appointed him Secretary of the Treasury, President Bush appointed Geithner President of the Federal Reserve Bank of New York. As such, he was responsible for the regulation of the largest bank holding companies in the USA. However, following standard operating procedure of the Bush administration, he did nothing. He sat in his posh office at the Fed and watched cash gush from the banks under his supervision. He watched assets dwindle, and then claimed in Congressional hearings that there was nothing he could have done. He even claimed that there had been too much regulation in many sectors of the financial services industry!

During his confirmation hearings, we learned that Geithner had not paid income taxes for several years. He apologized and paid the back taxes. The man chiefly responsible for re-invigorating our economy, the man with degrees in international economics and experience in domestic banking, did not have the financial acumen and legal awareness to pay his own taxes.

So, we have laws that encourage unethical behavior and fraud, and we have government officials who do not pay their taxes, accept money from the organizations they are supposed to regulate, and ignore what they cannot cover up.. This is a scenario that Lewis Carroll would have thought too implausible for Alice’s Adventures in Wonderland.

For more on coverups, go to www.PBS.org and look at Bill Moyers’s interview of William Black, the author of The Best Way to Rob a Bank is to Own One.