Roubini: Don't Believe the Stress Tests or the Bank Rally

Dr. Doom has an op-ed in the WSJ today. It's basic message is: The rally is an illusion and the stress tests are a fraud due to overly optimistic assumptions. If you thought nationalization or bondholder restructuring were off the table, you were wrong. The banking sector, he says, will lose a total of $3.6 trillion, meaning it's basically entirely insolvent.

He proposes three things. One is a renewed emphasis on getting the PPIP going. He's actually been pretty consistent on this, since the program has such vociferous critics.

True, the program offers cheap financing and free leverage to institutional investors, which will lead to the investors overpaying for the assets. But it does promote price discovery and remove the assets from the bank's balance sheets -- necessary conditions to move forward.

And to minimize the cost to taxpayers, banks must not be allowed to cherry-pick which legacy assets to sell. All the risky loans and securities banks were never meant to hold should be on the block. With enough investors participating in the PPIP program, the prices of the assets should be competitive, and there should be no issue of fairness raised by the banks.

Second, we need to end with the various no-string-attached guarantees and loan programs that are propping up the banks

Finally, he says the Congress must fast track a law that would give the government the authority to unwind or restructure complex financial instrements

And we shouldn't hear one more time from a government official, "if only we had the authority to act . . ."

We were sympathetic to this argument on March 16, 2008 when Bear Stearns ran aground; much less sympathetic on Sept. 15 and 16, 2008 when Lehman and A.I.G. collapsed; and now downright irritated seven months later. Is there anything more important in solving the financial crisis than creating a law (an "insolvency regime law") that empowers the government to handle complex financial institutions in receivership? Congress should pass such legislation -- as requested by the administration -- on a fast-track basis.

The mere threat of this law could be a powerful catalyst in aligning incentives. As the potential costs of receivership are quite high, it would obviously be optimal if the bank's liabilities could be restructured outside of bankruptcy. Until recently, this would have been considered near impossible. However, in 2008 there was a surge in distressed exchanges of debt for equity or preferred equity.