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Bank Stress Tests: 'This Whole Process Has Been a Fiasco'

The bank stress tests may not only be misguided policy, critics say, but may actually conflict with two other key government initiatives to stabilize the financial system.

With the government set to release the official results Thursday afternoon following a steady stream of leaks to the news media, criticism of the stress tests is growing.

“This whole process has been a fiasco,” says banking analyst Bert Ely. "There are strongly different opinions on the conditions of these banks. This has aggravated it without necessarily settling anything. The majority of the sentiment in the market is that the stress tests results [will be] too optimistic."

The stress tests, which are aimed at determining a bank's vulnerability to a severe downturn, also appear to conflict with the government’s plan to sell toxic assets and new regulation over so-called too-big-to-fail institutions.

“I think the government’s policies have all run against each other,” says Paul J. Miller, banking analyst at FBR Capital Markets. “They keep throwing things out there to see what sticks.”

Opponents view the stress tests as nothing more than a band aid on the wound of a body with massive internal bleeding—that’s where the other programs come into play—creating a false sense of security about the industry.

The stress tests may be intended to shore up banks capital, but a bigger problem for the industry and the economy is the estimated $1.5 to $2 trillion in toxic assets clogging up their books. More capital will not solve that, these critics say, especially if it is done through some of the preferred measures, such as converting preferred stock into common shares.

Ely calls that window dressing. “That does not put a single additional dollar into the bank,” he says.

It does help banks increase their tangible common equity, which has become something of an unofficial metric for the Obama administration. But critics consider it more of an accounting move that has no real impact on bank’s balance sheets.

“It doesn't change anything fundamentally,” adds Miller. “You cannot continue to have non-performing assets grow at 50 percent a quarter. Losses will swamp earnings.”

Miller’s firm subscribes to the theory that there’s another wave of home foreclosures that will put further pressure on balance sheets.

Miller says banks’ hold-to-maturity assets are also troublesome. ”They bleed over time and will get worse quarter to quarter.”

“Our argument is that because we are not addressing the real problem in getting these toxic assets off their balance sheets we're just going to jump from crisis to crisis.

A seal of government approval—before or after need capital injections—will make it even less likely banks will participate in the government’s Public-Private Investment Partnership to move toxic assets.

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Banks indicated an unwillingness to participate from the outset. The government then lessened the incentive by making a subtle yet powerful change in the mark-to-market accounting rule.

“The only way to sell them is to get them to write them down,” says Robert Glauber, who supervised the Treasury Department’s efforts in the savings-and-loan rescue two decades ago. “The regulators have let the banks hold them.”

Some have suggested the stress tests—and the contingent government aid being offered—are a chance to get the banks to participate in the PPIP, even if doing so would create losses and increase the amount of capital they need.

“My theory is the stress tests will be government leverage to get firms to participate in the PPIP,” says Zach Pandl, an economist at Nomura Securities. “There’s not a lot of incentive to be the first bank to participate in the program. Most would prefer to wait and ride it out as prices go higher.”

Though the PPIP has already attracted dozens of would-be buyers, observers say don’t expect the government to strong arm sellers into the program.

“They don’t have the stomach to do it,” says Glauber.

What about too-big-to-fail banks?

The stress tests also have the capacity to create another obstacle for Washington’s crisis management efforts—emerging legislation meant to give the federal government new powers to take over and, if necessary, shut down so-called “too-big-to-fail” institutions.

Government efforts dating back to the Bush administration have added to the group of big banks through shutgun marriages, creating rivals to Citigroup , which was once in a league of its own.

Wells Fargo , Bank of America and JPMorgan Chase have all grown enormously through acquisitions.

Many expect the stress tests to yield even further consolidation, as the smallest of the 19 banks struggle to raise capital.

List of Stress Test Companies:

“I find it kind of ironic when everybody talks about breaking up these big guys that the consolidation process is going to continue,” said Ely.

Ely says two to four of the smaller banks in the group—which all have assets over $100 billion—could be consumed by the end of the year.

“The ones that are good are going to buy their way out,” says Gerald O’Driscoll, a former Fed official who also worked at Citigroup.

JPMorgan Chase boss Jamie Dimon recently raised the possibility of additional acquisitions, having already absorbed Bear Stearns and Washington Mutual earlier in the crisis.

The too-big-too-fail legislation, which will be folded into a broader regulatory overhaul package, has broad support, from Congress to the White House and has grown more urgent, as the government has been in the embarrassing position of repeatedly providing capita to big firms such as Bank of America, Citigroup and AIG .

“Some institutions are too big to exist because they are too interconnected,” Sen. Richard Shelby (R-Ala.) told CNBC. “The regulators can't regulate them.”

Some say the resolution authority will go so far as to empower the regular in charge to judge a banking industry merger’s potential threat to the system.

“Does this regulator have the ability veto mergers that would create a bank that is too big to fail,” asks Lawrence White, a former regulator and White Hose economist now at NYU’s Stern School of Business. “A lot of this has to be for the future so we never go through this again.”

The trend toward bigger banks is even more worrisome to some analysts because authorities have typically allowed the biggest banks to operate with the smallest capital cushions, which hardly jibes with the purpose of the stress tests.

“We don't need more concentration in banking and ever larger firms,” says former FDIC Chairman William Isaac.

White, Glauber and others say its very likely their government will be forced to intervene and help again, regardless of the stress test results, whether it's more bailout capital or regulatory forbearance.

“I think they do have to go back to the well, “says Robert Glauber.

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