After the government released the results of the Stress Tests, the writers of DeltaHedged had an e-mail exchange.

DH: hoax, not a hoax, why?
my take: i just don’t hvae that much faith in these regulators knowing the value of the banks loan portfolios; huge swaths of portfolios of cmbs, corporates, you name it, all marked at shallow discounts
that’s what the stress test is really - just what the fed thinks the assets are worth
thoughts?

CT: consideration is that its the government who determines what “capitalized” means.  so if govt sanctions $35bn as the hole with that needs filling in order to for BAC to be “healthy”…then something tells me they (the govt) will defend that number till the cows come home.  judge jury and executioner.  so much for independence.

NC: My take: Better than nothing?
The truth is that the taxpayer is going to have to eat this. The Chinese bailed out their banks in their NPL crisis (which is effectively what the subprime crisis represents) by just buying the loans off of banks’ balance sheets at 100 cents on the dollar. They established specific corporations to handle this (they were dubbed “Asset Management Companies” (AMCs)). The AMCs then auctioned off the NPLs over time, instead of flooding the market with them. They fetched (at best estimates by outsiders) about 30 cents on the dollar.
Is it fair? Probably not, but maybe.
Probably not because it’s the banks’ fault, moral hazard, etc.
But it may in fact be fair for a couple of reasons. There’s the Milton Friedman argument: Corporations primary responsibility is to chase down maximal value for their shareholders, which is what getting in on the subprime game was. Second, the banks were within the bounds of the regulatory framework in place at the time. Banks are so critical to the functioning of the financial sector that they are highly regulated and in exchange receive some kind of implicit government guarantees (namely, that in the event of a meltdown the gov will step in and prevent calamity).
Tying in to the stress tests: The value the government places on the balance sheet portfolio of banks represents in essence what the government is willing to pay in the event of disaster, and thus their true market value is somewhat irrelevant.
Given that valuation, the government is perfectly capable of establishing what the banks need in terms of capital.
I think the valuation stands.

DH: Interesting, but I honestly would have preferred inaction instead of the stress tests.
I think that the stress tests come down to one thing: credibility.
The market has to ask itself if the government’s valuation of these assets is credible.  Mike seems to think that this credibility doesn’t matter, since the government, implicitly, is the buyer of last resort.  Look at China, he implores.
Are you really suggesting that the only solution is for the government to pay par (or something so much exorbitantly higher than the intrinsic value of the assets that it’s nothing more than another overt subsidy)?  In this case, yes, fine, the stress tests are irrelevant - either way, the taxpayer gets screwed.
I don’t know why you’re so willing to accept that.  If you’re right, the government has pinned itself in a miserable position deliberately.  If you’re wrong, then the government just released a stress test that has no credibility and zero relation to the true value of loan portfolios.
The best part of the stress test has to be the fact that some institutions are viable and profitable without any more capital injections.  We have an industry that has gone through a period of stress, out of which there remain several key market players with an enhanced industry position (JPM, GS) relative to their competitors (C, BAS, etc.).  We have elements of a viable financial system with a handful of viable firms.
Backstopping every single obligation on Citi and B of A’s balance sheets erodes this natural market mechanism of intraindustry differentiation - sure, it’s purgative and painful, but at least successful firms rise to the top, decoupling dead capital from unviable institutions.  What other industry would receive such special treatment?  Pets.com didn’t receive a bailout simply because Amazon.com remained popular after the 2001 tech bubble burst.
And while I don’t know much about the Chinese fiscal situation at the time of their NPL crisis, I’d assume they weren’t passing $1.8T budgets with borrowed funds from abroad.
The stress tests do nothing more than give a false hope to an industry that badly needs consolidation.  Instead, as you assured us, the taxpayer must bear the brunt of overpaying for the assets since regulators have abandoned any faith in the normal functioning of a price mechanism to determine true worth.
May our children forgive us.

NC:
1) You don’t have children.
2) The government poured money into the banks to recapitalize them. They bought preferred (soon to be common?) at par. Corporate finance 101: They were equity investors, thus they were staking a claim on the assets of the company over the face value of debt. The assets are the bad loans, marked at whatever the bank’s internal finance division chooses to mark them.
3) Keynes (apparently the Messiah of the Obama administration) would argue that investor confidence is key. Thus, a little confidence booster has real value.
4) I thought you were arguing the stress tests are bunk.
5) Isn’t this already happening? JPM and GS are already outshining the pack, regardless of government moves.
6) Pets.com was a systemic actor.
7) True. But again I ask, how can buying equities to recapitalize while the banks still hold the NPLs expand credit?  We’ve already seen massive consolidation. See above the value of restoring confidence.  Plus, I think the normal functioning of the price mechanism would put a bid price of $0.00 on the subprime assets. What would the results of that be?

DH:
I might not have children, but when I do, they will be saddled with lots of debt and a worthless currency…  Intermediate Corporate Finance: Even if preferred investors are technically equity, their payoff is fixed; they’re simply junior to the debt but above the common; with capped upside.  I’m not sure what point you’re trying to make - that they want to maximize the value of the assets to have a token equity return?  Funny if this plan involves them buying the debt and overpaying for those very assets - they still overpay for the debt under your plan.
Let’s say the private sector can’t cough up the necessary amount for the banks that need to raise capital.  Then, as you said in your original e-mail, the government foots the bill and makes up for this shortfall.  What happens then?  Banks like GS and JPM are penalized for being profitable, since unprofitability earns them - yes - another subsidy.
What if the private sector can’t cough up the necessary amount for the banks that need to raise capital?  Then, as you said in your original e-mail, the government foots the bill and makes up for this shortfall.  What happens then?  Banks like GS and JPM are penalized for being profitable, since unprofitability earns them - yes - another subsidy.
NC: All fair criticisms.
My main point was that the government should buy the assets directly off of the bank balance sheets. Instead, they have bought equity in the firms, which is a claim to the assets side of the balance sheets. Counted in those assets are NPLs. So, in a circuitous fashion, they have bought the NPLs, without actualy taking them off the banks’ balance sheets.