TARP Panel Report Gives Lukewarm Review to Stress Tests

A report by the Congressionally-appointed panel overseeing the Troubled Asset Relief Program, or TARP, gives a lukewarm-endorsement to the Obama administration's exercise of testing the financial health of the nation's 19 largest financial institutions, saying the stress tests were "constructive" but also "raised serious questions."

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The report of the Congressional Oversight Committee, or COP, will be presented in its final form to the Joint Economic Committee of Congress Tuesday, when its chairman, Harvard University professor Elizabeth Warren, is scheduled to appear before the panel.

A 50-page draft version of the report concludes that the “Federal Reserve used a conservative and reasonable model to test the banks, and that the model provides helpful information about the possible risks faced … and a constructive way to address those risks.”

At the same time, however, the report said there were “some serious questions” about the stress test process — from methodology to transparency — and offered a half-dozen recommendations.

Under the tests, whose results were released in May, the Obama administration asked federal regulators to examine how financial institutions would hold up under two different economic scenarios as well as how much new capital they would need to raise to shore up their balance sheets.

The tests concluded that ten banks — including some of the biggest, such as Citigroup , Bank of America and Wells Fargo — would need to raise almost $75 billion in capital; the firms were also required to present plans on how to do so by June 8. The government is prepared to loan money to those companies that are unable to raise capital from private sources.

The COP panel was created under the Economic Emergency Stabilization Act, which was signed into law in October 2008 and authorized the Treasury to spend up to $700 billion in propping up the financial system.

The findings of the five-member panel have sometimes been split along party lines, given Warren and two other members were appointed by Congressional Democrats. The two Republican members are Rep. Jeb Hensarling (R-Texas) and former New Hampshire Senator John E. Sununu.

The highly anticipated stress test report is partly the work of outside consultants.

The committee said it used two "internationally-renowned experts in risk analysis" to review the process; they are Professor Eric Talley, Co-Director of the Berkeley Center for Law, Business and the Economy at the University of California, and Professor Johan Walden, an assistant professor at the University's Haas School of Business.

In particular, the report says "unanswered questions" about the details of the tests, make it impossible to "replicate the tests to determine how robust they are or to vary the assumptions to see whether different projections might yield very different results."

The report also cites potential shortcomings of the assumptions used for the two economic scenarios because of worsening conditions in some cases and the relatively short time frame used in the models, which "may fail to capture substantial risks further out on the horizon."

Stress Tests Should Be Repeated If Unemployment Worsens

The tests, for instance, used worst-case scenario data for economic yardsticks such as the unemployment rate and mortgage delinquencies.

The report notes that the jobless rate is now 9.4 percent, with a 2008 average of 8.5 percent. "If the monthly rate continues to increase during the remainder of this year, it will likely exceed the 2009 average of 8.9 percent assumed under the more adverse scenario," the authors note.

For this reason and others, the tests should be repeated, as much as necessary, partly because "banks continue to hold large amounts of toxic assets on their books".

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The report's key recommendations also include: the release of more information on the test results; a more transparent repayment process for firms receiving financial aid; and better disclosure on how the Treasury Department would use repaid TARP funds.

In one way or another, TARP has been highly controversial from its inception in the Bush administration through its latest reincarnation with the Obama administration.  Observers say how and when the money gets paid back has become as much of a political football as how its been used by banks.

COP Chairman Warren has been highly critical of both the government’s administration of TARP and banks use of the money.

COP member Hensarling Monday introduced legislation calling for the termination of the program by the end of 2009, saying, "the economic justification for TARP’s creation and taxpayer assistance to financial institutions no longer exists."

Critics say though the stress tests appeared to partly achieve the goal of helping to rebuild confidence in the financial system, they may have also created a false sense of security about the health of banks, which is partly reflected in the stock market’s hearty comeback.

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The COP report’s conclusion literally ends on that point:

"The short-term effect of the stress tests was positive, and the financial markets have calmed to some extent. The Panel concludes that it would be as much a mistake to dismiss the stress tests as it would be to assign them greater value than they merit or in fact that the supervisors claim for them. The fact that the holding companies have added certain amounts of capital on certain assumptions does not mean that the financial crisis is over or that the holding companies are now free from the risk of the sort of crisis-laden conditions many found themselves experiencing during 2008 and early 2009."

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