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Was The Stress Test A Con All Along?

Wall Street finished the week with another champagne-popping rally as investment managers exhaled after the government published the results of its stress tests on the nation's major banks.

The healing process has begun, Quincy Krosby, the chief investment strategist at Hartford Investments told the New York Times. "You're seeing more conviction buying the banks, where investors are culling the weak from the strong and going into the strong names. The strong will get stronger and the weak will get weaker."

But the headlines buried the real lede.

On the face of it, Wall Street's rally came in response to the better-than-expected news that 10 of the banks must raise $75 billion in new capital. Turns out, however, that the banks had a significant hand in shaping the outcome of their own government-administered exams.

The Wall Street Journal is reporting that that the smaller-than-expected deficit number came about because the Federal Reserve applied a "different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits." The Journal reported that:

"when the Fed last month informed banks of its preliminary stress-test findings, executives at corporations including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. were furious with what they viewed as the Fed's exaggerated capital holes. A senior executive at one bank fumed that the Fed's initial estimate was "mind-numbingly" large. Bank of America was "shocked" when it saw its initial figure, which was more than $50 billion, according to a person familiar with the negotiations."
Quoting sources said to have first-hand knowledge of the process, the Journal said that "at least half of the banks pushed back." The argument: The Fed had low-balled the banks' ability to make good on "anticipated losses with revenue growth and aggressive cost-cutting. Others urged regulators to give them more credit for pending transactions that would thicken their capital cushions."

In the haggling that ensued, the banks also complained that regulators' initial findings were much stronger than the government's methodology would report. The Times is reporting that in order to offset any capital shortfall, the banks were allowed to use asset sales they had already booked "as well as profits that were better than the government projected for the first quarter."

Of course, not every bank's projected capital needs got reduced. Some institutions were informed they had a capital shortfall whereas earlier, their managements had been under the impression that they would not require new capital. For the most part, however, the stress test revisions came as a pleasant surprise. Most important, the news fostered the impression that the state of the banking industry was a lot better than many had feared.

As the story behind the story begins to trickle out, Barry Ritholtz, the CEO and director for equity research for Fusion IQ, called the exercise "one giant joke-and the laugh is on the taxpayers."

"The Stress Tests were done using 'Tier 1 common capital' as a yardstick," he wrote on his blog. "We can assume that was also pushed by the banks, rather than the expected metric "tangible common equity." That measure would have required another $68 billion in capital."

If all this works to restore confidence in the financial system, then Treasury Secretary Tim Geithner will have realized what he set out to do and reestablish calm. In the meantime, though, he's going to hear accusations that the stress test was a con game from start to finish.

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