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Good article on the politics of the stress tests


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From an organization that thinks that the FED has been too lenient but the reporting is good. For example, this is the background of Moynihan's embarrassing rejection on the previous stress test.




Once Dodd-Frank was passed in the summer of 2010, making bank supervision a more vital part of the Fed’s mandate, the board of governors wanted to monitor Tarullo’s efforts, so the board requested regular briefings. One governor, Kevin Warsh, a George W. Bush appointee, viewed the Fed’s overall bank regulatory approach skeptically. Something of a libertarian, he thought that the Fed was overly confident in its abilities to monitor banking activities and head off crises before they became acute.


But Warsh, who oversaw financial market activities and not regulation and supervision, also worried that the banking system had too little capital. Do the banks have enough to offset losses? Do their books accurately value their assets? Do they have the proper risk management systems in place? he worried to colleagues. “There is too much confidence that these institutions won’t find themselves in the soup again,” Warsh tells ProPublica.


But the Fed had boxed itself in with its standard: The regulator had told the banks that if they hit their capital requirements under the stress-test scenarios, they could pay dividends and buy back stock.


Ultimately, the Fed did not allow every bank to increase dividends. Some banks, like Citigroup, didn’t request an increase after a signal from the Fed that it would be turned down.


In at least one instance, a signal was misinterpreted. Early in the process, the Richmond Fed left Bank of America with the impression that it would pass the stress test and be allowed to raise dividends. Encouraged, the bank asked permission. In late 2010, Chief Executive Brian Moynihan suggested to investors that a raise would come in the second half of 2011. But in the end, the Fed nixed any dividend raise. The Fed and Bank of America declined to comment on this incident.


A triumph for Tarullo, the episode nevertheless harmed investor confidence in Bank of America and its management, becoming one of the more embarrassing in Moynihan’s tenure at the bank.


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One major concern was accurately measuring legal liabilities. Banks that had assembled mortgage-backed securities often faced accusations of fraud or deception from investors in those securities. Now, the banks faced a threat that courts would force the banks to take back billions of dollars’ worth of toxic mortgages, known as “put-back” risk. With input from the legal department, the Fed had come up with a system-wide estimate for this risk that the FDIC considered too low, according to two people familiar with the process.


Worse, by the fall of 2010, banks had an emerging legal threat to worry about: foreclosure problems. In the aftermath of the housing crash, banks had abused the rights of homeowners in the process of foreclosing. The most publicized issue was “robo-signing,” in which banks had documents automatically notarized by people who weren’t reading the materials or checking for inaccuracies. As this threat emerged, banks came under investigation by state attorneys general and faced billions in new potential legal liabilities.


“The highly publicized mortgage foreclosure process flaws provide an example of how quickly material issues can arise in these institutions and how they are still exposed to the poor decisions made in the years leading up to the crisis,” Bair warned Bernanke in her letter.


Estimating these future liabilities was a task the Fed delegated mainly to the banks. In a Dec. 12, 2010, speech, Tarullo said the Fed expected “that firms will have a sound estimate of any significant risks that may not be captured by the stress testing, such as potential mortgage put-back exposures, and the capacity to absorb any consequent losses.”


But the various foreclosure problems were just emerging, so estimating those liabilities was difficult — though it was clear that they could be huge.


The FDIC was puzzled. “The direct connection between the put-back issue and the stress test never has been clear to me. They didn’t take the number and add it to the bottom line,” says the senior regulator familiar with the FDIC’s position. “They didn’t have any sizing on broader servicing liabilities.”


All the more reason, FDIC officials thought, to slow down the dividend payouts and stock buy-backs.


The Fed did have an effort parallel to the stress test to assess these liabilities, and, according to a Fed spokeswoman, eventually included the legal risks in the stress test.

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