Whose Fault Is It Anyway?

Now we know - courtesy of Rolling Stone magazine: it's all Goldman Sachs's fault. The destruction of untold wealth, jobs and all the global economic pain of the past two years? All down to one firm. So let's smash the evil empire and move on. But wait, this isn't a movie. This is real life. And in real life, nothing is simple and straightforward and there's very rarely an single scapegoat.

The financial crisis of 2008 was the culmination of a shift in Western societies toward financially-driven economies; a shift that began with the various Big Bangs of liberalization of financial markets in the 1980s, that was driven forward by central banks' success in taming inflation and that hit several small peaks - the S&L crisis in the U.S., the Russian default/Asian crisis, the dotcom bubble, the Enron/WorldCom collapse, the massive teleco debt accumulated in Europe - before exploding in our faces in late 2008.

At every turn, after every crisis, we as a society - here & abroad - had the chance to put a halt to the economy's inexorable progress toward the cliff's edge. Most recently in 2002 when credit markets froze after the Enron/WorldCom debacle. Had supervisors and regulators then done more than just fret over ratings agency incompetence, taken action instead of twiddle their thumbs over the dangers posed by off-balance-sheet vehicles, perhaps some of the more egregious abuses could have been prevented.

But they didn't and why should they have? We as a society decided that financial markets should rule unfettered, we voted into power the politicians who supported the view, we tuned into CNBC, we wanted to get rich by buying low and selling high - and the devil take the hindmost. Politics boiled down to tax cuts and the demonization of any kind of state action. And even when left-wing parties came to power, the kow-tows to the financial markets continued.

We're all responsible for what happened in the past year - not just the bankers. And getting out of this will the recognition that a stable, balanced economy comes at a price: higher taxes, bigger government involvement in the economy and far smaller profits - for all. Not just the bankers at Goldman Sachs.

Bank Stress Tests II - Managing Expectations

So what's the likely upshot going to be on the bank stress tests? The government will end up converting its preferred stock into common shares of several of the major banks; the New York Times' list of common tangible equity levels makes it clear that Citigroup seems a definite candidate for the regulator's "must do more" list; Goldman and JPMorgan are unlikely to be allowed to pay back their Tarp funds immediately. After all, the point of the stress tests is to ensure that major banks end up holding "additional capital to provide a buffer" in case events take a turn for the worse - and while the two banks certainly have more capital than some of the others, that presumably is what regulators mean by "buffer".

That's not the only argument that regulators can wield in the debate surrounding the repayment of Tarp money: there's also the issue of what's good for the economy as a whole. Banks are a key conduit to get credit into the hands of consumers and businesses - even more so because the credit markets remain broken. Regulators are trying to manage the transition from a system in which the unregulated securitization markets took care of a hefty chunk of credit flows to the broader economy to one that relies more on the regulated banks. And they're doing this at a time when risk appetite, while better than late last year, is still pretty shaky. Sky-rocketing corporate defaults could yet send corporate debt markets into a tailspin - markets by the way that still require a fair amount of government support - we still don't know what shape the recovery will take (W or L or U - one hopes for U but can't exclude the other two). Most tellingly, the first quarter profits in the banking sector came mostly from fixed income trading - hardly a sustainable earnings driver.

So where does that leave markets? About where they are - if regulators and the banks themselves manage the results of the stress tests and their consequences properly. Financials will continue to gyrate but we shouldn't see the kind of selloff we saw last year. Bank debt spreads and CDS remain wider than normal, and rightly so, these aren't normal times. But managing the fallout won't be an easy task. The Fed notes in its white paper that "a need for additional capital or a change in composition of capital...is not a measure of the current solvency or viability of the firm." One can only hope investors are listening.