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What Treasury Needs Is A Distraction

The bank stress tests are beginning to create a perception problem, but not--as you might think--for banks. Rather the issue is top level Administration officials' own optics (spin jargon for how we think about our rulers).

At one level, the government's approach to banks--delay doing anything until the economy stabilizes--is working out nicely. This is the counterpart of the macroeconomic Summers Strategy and in principle it is brilliant. "Don't just do something, stand there," is great advice in any crisis--eventually everything bottoms out and you can take the credit, justified or not (unless an election catches up with you first; check with Herbert Hoover.)

But American bankers apparently just cannot cooperate by lying low, keeping their mouths shut, and refraining from anything that looks like picking other people's pockets.

As the banks' financial prospects improve, their political clout picks up and they increasingly resist the Fed and Treasury on many fronts, including the stress tests. Then we find out this weekend that Charles Munger, Vice Chairman of Berkshire Hathaway, walks softly and carries a big pitchfork; speaking of bankers, he said:

"This is an enormously influential group of people, and 90 percent of that influence is being spent to gain powers and practices that the world would be better off without," Munger, 85, said yesterday in an interview with Bloomberg Television. "It will be very hard to accomplish the kind of surgery that would be desirable for the wider civilization."

Monday morning, we learn that Stephen Friedman, the chairman of the New York Fed (a) did not divest his Goldman stock when Goldman became a bank holding company and thus subject to the Fed's jurisdiction (not good), (b) bought more Goldman stock in late 2008 (looks bad, including to Senate Banking), and (c) did not disclose this purchase to the Fed (very bad, optically speaking).  Berkshire Hathaway owns a great deal of Goldman stock--is this part of what Mr. Munger was trying to tell us?

"We need to remove from the investment banking and the commercial banking industries a lot of the practices and prerogatives that they have so lovingly possessed," Munger said. "If they are too big to fail, they are too big to be allowed to be as gamey and venal as they've been--and as stupid as they've been."

In any case, this is a serious problem for Treasury's optics. After long negotiations, the bank stress tests were set to show most banks are close to have their Goldilocks level of capital (i.e., just right). Given that we generally agree (and the President has long stressed) this is the biggest financial crisis since the Great Depression, we seemed to be on the the verge of a capital adequacy miracle.

But instead of this being seen as some combination of good luck and smart policy, "everyone is basically fine" would look like the banks are running the show. My Treasury friends swear up and down this is not true, but that is now beside the point. Whatever the reality, it looks increasingly to everyone like the banks really are in charge. It's a nasty rule of politics that you are damaged by where perceived blame lands, rather than by what you actually do.

How should Treasury handle this? They've tried the standard stalling tactics, but pushing the stress tests into the weekend news cycle would be a bit too blatant; "late on Thursday" remains the current announcement time. 

If only Charles Munger hadn't been quite so eloquent.

Munger said the financial companies spent $500 million on political contributions and lobbying efforts over the last decade. They have a "vested interest" in protecting the system as it exists because of the high levels of pay they were earning, he said. The five biggest U.S. securities firms, only two of which still exist as independent companies, paid their employees about $39 billion in bonuses in 2007.

"They would like to get back as closely as possible to business as usual, and they have enormous political power," he said.

Back in February, I suggested that we were about to witness a showdown between Secretary Geithner and US banking interests. Some very smart people are working nights, trying to figure out how to prevent the full outcome of this confrontation from becoming focused in the public's mind. My guess is that Charles Munger is not at this point on the team,

Berkshire Hathaway Inc. Vice Chairman Charles Munger, whose company is the largest private shareholder in Goldman Sachs Group Inc. and Wells Fargo & Co., said banks will use their "enormous political power" to prevent changes to the industry that would benefit society.

Munger said policy makers should seek to impose limits on banks that are deemed "too big to fail" after financial institutions worldwide suffered more than $1 trillion in losses. The U.S. government and the Federal Reserve have spent, lent or committed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the recession.

What Treasury really needs is a distraction. Doesn't anyone have a big positive, or at least controversial (and not related to banking), announcement they'd like to make on Thursday? 

You could, of course, make the stress tests appear more meaningful by focusing on a headline, "10 out of 19 banks need capital" (but how much?). Given the recent market rebound and stronger general confidence, this may be where we are going. Presumably Treasury will give banks plenty of time to raise this capital and provide extensions as needed. 

Treasury wants to wait and essentially do nothing, at the same time as appearing decisive. This is a tough combination to pull off. And what will the banks get up to while you are waiting?

[Cross-posted at The Baseline Scenario.]

--Simon Johnson