Stress Test: Reflections on Financial Crises

Timothy F. Geithner


592 pages, $35

By Michael D. Langan

News Book Reviewer

All of us are familiar with medical stress tests. They’re drills the doctor puts us through to see whether we’ve got enough stamina left to pay his bill when he sends it.

Banks have similar stress tests. Here’s one definition by Investopedia: “Stress tests focus on a few key risks – such as credit risk, market risk and liquidity risk – to banks’ financial health in crisis situations. The results of stress tests depend on the assumptions made in various economic scenarios, which are described by the International Monetary Fund as ‘unlikely but plausible.’ ”

By now the IMF may wish to modify the wording to “you’d better watch out.”

The international banking industry has been paying greater attention to these tests – of varying value depending upon who’s conducting them and what they are measuring – since 2009. That was the year when the financial crisis found many banks and financial institutions severely undercapitalized.

For many institutions this was not a mistake. Banks were not caught unawares. The undercapitalization was done on purpose. Banks leveraged with excessive risk and got caught.

About this Ben S. Bernanke, head of the Fed at the time, later remarked that there had been too much borrowing – as well as hazardous reliance on short-term funding and negligent risk management, with lax regulatory supervision by the government.

This is the subject of Timothy F. Geithner’s new book, “Stress Test.” Geithner is now a fellow at the Council on Foreign Relations. Earlier he was president of the Federal Reserve Bank of New York and then President Obama’s Secretary of the Treasury.

“Stress Test” is Geithner’s set of reflections on the financial crises and, as his publisher puts it, “…the inside story of how a small group of policy makers – in a thick fog of uncertainty, with unimaginably high stakes – helped avoid a second depression but lost the American people doing it.”

Well, Geithner certainly got that last part right. You have to wonder why they settled for sitting in a thick fog with so much at risk. I think part of the answer is that economists, regulators and government missed the huge train of debt hurtling down the tracks. It almost destroyed Main Street while switching tracks to avoid Wall Street. One would think that after this debacle, there would be a better plan by regulators to manage the risk so that both streets get appropriate attention. Raising bank capital levels globally earlier would have diminished the risk.

Many people, their jobs or retirements diminished or lost, are still steaming at the ineptness of the rescues and collapses within the economy six years ago. Bear Sterns was saved, Lehman Brothers tanked; AIG was salvaged despite stories of how that firm paid bonuses while the company was in free-fall. There are seismic shocks to this recession still playing out: high unemployment, battles over deficits and debt, and Europe’s continuing struggle with its nations’ bankruptcies.

What are the takeaways from Geithner’s book?

• It appears that he helped minimize the likelihood of a Second Great Depression. He proposed that the Federal Reserve review banks’ books – a stress test - to see if they were able to withstand a further economic decline. A good review by the Fed enabled banks to begin lending again and demonstrate sufficient capital to do so.

As Charles Lane points out in Politico, “Whether aimed at Geithner from the left or right, the basic criticism of his approach was essentially the same: that shielding reckless financiers from the full consequences of their actions, monetary and legal, is not only wrong but also encourages similar behavior by others in the future.” And Geithner himself acknowledges that “moral hazard” is an inherent feature of government intervention in financial crises. Geithner himself says, “We weren’t perfect. It was messy. We had to learn as we went along.”

Others continue to point to Geithner’s lackluster performance. A new book by economists Atif Mian, at Princeton, and Amir Sufi, from the University of Chicago, make the case in “House of Debt” that Geithner and Bernanke aimed at the wrong target. They say he and others should have figured out how to help homeowners reduce their mortgage debts. Saving the banks was “an insufficient mantra,” they write.

• Geithner’s view was that government didn’t have the choice not to take the risk. Not to have acted as the government did was, he thought, to incur an even greater doomsday scenario. The problem was that at the start of what Geithner calls a “financial fire” in the country and beyond, one didn’t know if it was systemic and would lead to a broader conflagration.

This remains a big problem. Banks ran away with the ball, enabling borrowers to make improvident loans that led to worthless mortgage securities. As Roger Alcaly, a hedge fund manager and author of “The New Economy,” writes, “The Federal Reserve … should have been questioning and restraining these practices.” The regulatory failures, Alcaly says, were induced by complacency, and permitted politicians and regulators to be intensely lobbied so that prospective reform since the crisis has been weakened.

• Still, as Geithner points out in his epilogue, it could have been worse. Part of Obama’s legacy is that he prevented a major depression. Charts on page 494 and following pages indicate that the United States’ recovery has outperformed the developed world. And, while “the shock that preceded our crisis in 2008 was larger than the initial shock that precipitated the Great Depression of 1929, our outcomes were dramatically better.”

• Finally, Geithner notes that the IMF’s estimate that U.S. government spending would be nearly $2 trillion rescuing the financial system wasn’t accurate. In fact, the government’s response at the end of 2013 projected to generate $166 billion in positive returns for taxpayers.”

This sounds great, but if you have no job it means nothing. It also doesn’t take into account what economists call the cost of capital that taxpayers extended to the banks, as pointed out by Gretchen Morgenson.

(Full disclosure: I was at the Treasury Department from the late 1980s to 1999, mostly as the senior adviser to the undersecretary for enforcement. My tenure came before Geithner’s time as secretary. Geithner was at Treasury at the same time as undersecretary for international affairs and other posts. He was well-known but quiet – in contrast to some other senior figures.)

In a number of ways, Geithner wasn’t Treasury’s best salesman. He had no flash and he wasn’t selling anybody a bright future. He did have a plan to muddle through and get in out of the rain, and that’s what he did for the country. He says that there wasn’t another option. Next time, let’s have a game plan that includes a bigger umbrella.

So the question now is: Has the American public the money to pay for the stress test that Geithner and others imposed on us?

Michael D. Langan served as an adviser for the assistant secretary for labor management standards in the Labor Department, and as senior adviser for the undersecretary for enforcement at the Treasury Department.