What Is Stress Testing?

It is a big week for America's 20 largest banks, as the Obama administration begins a process of stress testing these beleaguered financial institutions. Ever since Treasury Secretary Tim Geithner's uninspiring performance on February 10, the markets have been scrambling to determine what the new financial rescue plan might look like. Even preliminary estimates suggest that Citigroup, Bank of America, Wells Fargo, JP Morgan Chase, Goldman Sachs, and Morgan Stanley all might need additional support from the government.

Much has been written about the murky details of Mr Geithner's public-private investment fund. Indeed, few analysts are convinced that the administration has announced little more than a plan to make a plan. More alarming, however, is the swirling doubt over the imminent stress tests, which appear to be one of the few concrete measures in TARP II. The government has said that these balance sheet evaluations will run a series of "what if" models that will simulate a bank's performance under increasingly adverse conditions (rising unemployment, falling home prices). Still, many are wondering: how will these stress tests work?

In general, stress testing models the valuation of capital under situations that are costly and rare. These test often simulate shocks at a greater intensity than historical data would otherwise suggest and simulate shocks that have never previously occurred. Under Mr Geithner's logic, such an exercise would help Treasury learn which banks are equipped to weather the financial storm, and which are insolvent. The results of the stress tests will not be made public (the institutions that fail could face nightmarish bank runs), the administration hopes to determine where its capital injections are best spent.

Here is the problem: for all intents and purposes, there will be no real stress tests. First, the sheer cost of true stress testing is prohibitive. The process involves an accounting process that would dwarf the post-Enron clean-up, and there is not remotely enough manpower or resources. What is more, a true stress test would almost assuredly require an increase in capital requirements for banks (precisely the opposite of what Mr Geithner wants).

Second, it is unlikely that any of the bank regulators dispatched to perform these stress tests are qualified to analyze today's byzantine financial instruments. The national crash-course in credit derivatives and structured products does not even begin to understand the toxic assets that have torpedoed our economy. A true stress test would measure the cascading consequences on liquidity and contagion of, say, credit default swaps; however, regulators familiar with traditional banking activities are (understandably) clueless on how to price these securities in the current market.

Third, there are reasons to suspect that there is real accounting fraud in the financial services industry. In the age of Bernie Madoff and Allen Stanford, it is somewhat surprising that more attention has not been paid to this scenario. Is it so inconceivable that the $100 billion hole in Lehman's balance sheet was criminal? Real stress tests will have to compare accounting numbers with the underlying documentation (original loan files). Often times, however, these documents are missing as subprime loan originators went bankrupt and simply discarded the files. In the nightmare scenario, crooked accounting practices will further obfuscate the stress tests.

At this point, most observers agree that any viable economic recovery plan requires clarity and commitment. The Bush administration was pilloried for its on-again-off-again responses to the financial crisis. In an effort to chart a new course, Mr Geithner had hoped to lay out a convincing bank rescue plan when he spoke two weeks ago. Unfortunately, the underlying specifics of his message are, at best, underwhelming and, at worst, entirely absent. It is time for new solutions for the banking system, the type Americans are culturally predisposed to abhor. Pre-privatization, anyone?

Mexico: The Border War

In Thursday's speech honoring the army's founding, Mexican President Felipe Calderón defended his decision to pursue military solutions to the country's violent drug war. Brutal clashes between armed drug smugglers accounted for more than 6,000 deaths in Mexico last year, and the 2009 pace is unabated. In response, Mr Calderón has sent more than 45,000 troops to battle Mexican cartels and patrol the most dangerous regions of the country.

The levels of violence in Mexico are staggering. The painful realities of narco-trafficking have long afflicted Mexican society, however, starting last year, there has been a remarkable escalation in the drug war. In September, a grenade attack in Michoacán State killed eight civilians and wounded some 100 more. Last month, another grenade killed a child as armed attackers gunned down two adults in Durango. On February 17, a major firefight broke out in Reynosa between Mexican authorities and armed members of a drug cartel. According to reports, government officials recovered RPG rounds and mortar rounds.

There is no doubt that the lethality of cartel attacks has increased dramatically since 2007. In addition to the heavy weapons used in the Reynosa standoff, smugglers are now using fragmentation grenades and assault rifles to assert their control in Mexico. Escalating violence and the impotence of the central government demonstrate that there is an active war in the country. More specifically, there are three wars.

First, rival drug cartels are fighting one another. While the picture of violence is increasingly dynamic, Mexican cartels are battling over regional supply routes into the US. In Baja California, the Sinaloa cartel is fighting the formerly-dominant Tijuana cartel. The Sinaloa cartel is also fighting a horrific battle against the Gulf cartel for the western Texas supply routes, and there is a multi-cartel struggle for the central Juárez-El Paso route. Control over these major Interstate corridors into the American drug market is an essential part of the billion-dollar narcotics industry.

Second, there is a war between the Mexican government and the cartels. Mr Calderón's two-year offensive against drug traffickers has been widely ineffective, and the resulting violence has put Mexican civilians in the crossfire. Brazen attacks against government officials and local police have convinced many observers that the situation is spiraling out of control. Earlier this month, Mexican drug gangs took over police radio frequencies, issuing death threats (some of which they then carried out) to uncoöperative authorities. In January, a Pentagon report concluded that Mexico was at risk of becoming a "failed state," and could face a full-scale collapse of civil government. Local officials rejected such analysis, but it is clear that Mr Calderón's war on drugs is backsliding.

Third, the alarming rise in civilian kidnappings in Mexico signals a war among the population. To be sure, cartels are often involved in abducting, torturing, and killing high level government officials or rival drug traffickers. But kidnappings appear to happen all across the country (not only in narco-zones) and are perpetrated by a range of actors. Some criminal gangs have developed complex strategies to abduct high-net-worth targets and command million-dollar ransom payments. Other more rudimentary criminals, target ordinary Mexicans in a short-term effort to drain their ATM accounts or extract modest ransom fees. This form of "express kidnapping" has a paralyzing effect on the Mexican population. Similar to terrorism, this war does not target institutional actors, but courses through the daily lives of average citizens.

One year ago today, then-Senator Barack Obama promised to repair the US relationship with Mexico. He made direct reference to the problem of drug cartels, but his solutions were broad and unspecific. Such politicking is to be expected from a candidate, but it will be interesting to see how Mr Obama's policies develop as president. Clearly, the new administration's focus is on the American economy. Nevertheless, the US-Mexico trade relationship is valued at more than $300 billion (the third largest of America's economic partnerships) and will be important to any sort of recovery.

Make no mistake, the violence in Mexico is as much an economic threat as it is a security challenge. Unfortunately, the level of corruption in Mexico (a function of the cartels' infiltration of government offices) means that the country cannot solve its drug problem alone. Indeed, the Mexican drug war is likely to be in an important part of the UN Commission on Narcotic Drugs next month. In reality, though, it will be an American problem before anyone else's outside Mexico. There is a war on the US border, and Mr Obama will have to help craft a solution.

Flower Power: Gaza's Valentine's Day Reprieve

For florists, chocolatiers, and restaurant owners, Valentine's Day is a green holiday. Behind the red hearts and resplendent bouquets are millions of dollars in sales. Even with a slumping economy, retailers are hoping that lovestruck couples will still open their pocketbooks to please their significant others.

The holiday is playing out in international politics as well. In an apparent goodwill gesture, the Israeli government confirmed this week that it would ease its blockade of the Gaza strip to allow Valentine's Day exports. Israel will allow some 25,000 flowers to be exported from the Palestinian territory to Europe, the first crack in a blockade that began in more than a year ago. Since Hamas took control of the Gaza strip in June 2007, Isreal has prevented the coastal region from participating in global trade. The blockade is widely seen as one of the main reasons for Palestinian smuggling tunnels that were the subject of Israeli airstrikes in Gaza. The flower export agreement marks the first time in a year that Palestinian goods will be able to enter the world market.

According to most analysts, however, the current reprieve is simply cosmetic. Mohammed Khalil, head of the Gaza flower growers' association, noted that the territory used to export 40 million flowers each year. By comparison, a mere 25,000 flowers are economically insignificant. What is more, many of the commercial flowers in Gaza have been destroyed (literally fed to animals) because they could not reach European markets. While Palestinians do not celebrate Valentine's Day, local producers had previously benefited from Western demand for flowers and heart-shaped chocolates.

Cut flowers and strawberries were some of the Gaza Strip's main exports before the blockade began, bringing a valuable source of income to the 1.5 million inhabitants of the coastal territory. Israel announced that the Valentine's Day measure did not indicate a shift in their overall trade policity toward Gaza. In short, the blockade will continue and border crossings will remain closed during the current political impasse.

Israel's election results are now official, but it remains unclear as to who will form a ruling coalition. Kadima's Tzipi Livni received the most seats in Tuesday's vote with 28 seats. But a hawkish bloc headed by Benjamin Netanyahu's Likud party, and including the new number three party, Avigdor Lieberman's Yisrael Beitenu, controls 65 seats of the 120-member Knesset, giving Mr Netanyahu the edge in coalition building. Israeli President Shimon Peres must now decide which leader can most effectively pull the country's factions together.

The decision will undoubtedly have an impact on the volatile Arab-Israeli peace process. At this point, it seems unlikely that the two sides are exchanging any Valentine's Day gifts.

The Munich Security Conference and Future US Diplomacy

The 45th Munich Security Conference proved to be one of the more exciting gatherings of top- and supreme-level politicians in the event's recent history. In contrast to the melancholy tone of the economic summit in Davos, about 300 security officials from across the globe came to Germany this past weekend with high hopes for diplomacy.

The event marked the first real opportunity for the new administration in Washington to outline its foreign policy objectives. Accordingly, President Barack Obama sent his VP Joe Biden to address the conference in a highly anticipated speech on Saturday. Mr Biden's introduction was welcomed with great applause and effusive handshakes, a clear sign that much of the world has been waiting to see fresh faces in the White House.

Pleasantries are one thing, policies are quite another. Mr Biden's opening remarks were certainly more conciliatory than similar statements under Bush administration officials, as he spoke of an American "renewal project" with old friends and recent adversaries. With respect to specific security challenges facing the US, however, the Vice President reaffirmed many of the hard-line positions that have heretofore vexed the international community. Speaking about relations with Russia, Mr Biden stated that, "The United States will not -- will not recognize Abkhazia and South Ossetia as independent states. We will not recognize any nation having a sphere of influence."

Before the speech, White House aides said that Mr Biden would announce the administration's willingness to reconsider a planned missile-defense system in Eastern Europe. Under the Bush administration, the US was slated to install weapons in Poland and a radar station in the Czech Republic that could intercept a nuclear attack from Iran and North Korea. For the Kremlin, however, these measures were thought to encroach upon Russia's near-abroad. In the week before the Munich conference, it seemed that Mr Obama, who is determined to restore relations with Moscow, would not push for the defense shield. Once Kyrgyzstan announced it would likely close its American military base (a move Russia is thought to have orchestrated), Mr Biden's speech was changed. He notably added a line saying the US "will continue to develop missile defense to counter the growing Iranian capability."

Even with this lingering standoff, Russian deputy premier Sergei Ivanov said that Mr Biden's speech was "very positive." His own remarks at the conference signaled the potential for greater communication and coöperation between Washington and Moscow. What is more, there are still politically viable ways for the US to back out of the missile defense shield without looking weak. With a $10 billion per year price tag, the system could (and certainly should) be scrapped for economic reasons.

Nevertheless, the Russian exchange demonstrates that many of the Bush-era frustrations cannot be solved with rehotic alone. As his Vice President explained, Mr Obama will ask European leaders for greater commitments to NATO forces in Afghanistan, which special envoy Richard Holbrooke recently described as "a long, difficult struggle." In addition, the Obama administration is likely to put pressure on the EU to support infrastructure development and democracy promotion across the border in Pakistan. For leaders with financial strains and war-weary electorates, American requests are no more agreeable than they were under George Bush.

Still, Mr Obama's rehabilitative efforts must count for something. The president's commitment to multilateralism lends credibility to his diplomatic efforts. The Bush administration made significant nominal changes to foreign policy during its second term, but few foreign leaders took them seriously. See the Iranian example. On Saturday, Mr Biden offered Tehran a familiar choice: "Continue down the current course and there will be continued pressure and isolation; abandon the illicit nuclear program and your support for terrorism, and there will be meaningful incentives." This policy doesn't sound much different than 6 months or 2 years ago. But British Foreign Secretary said that there is a genuine commitment among the new American administration to put direct talks with the Iranian regime on the table.

The next major foreign policy stage for the US is Secretary of State Hillary Clinton's trip to Asia, where she will visit capitals in Beijing, Seoul, Tokyo, and Jakarta. The fact that her first trip is not to Europe or the Middle East simply demonstrates how many issues US diplomatic efforts must address.

Why Aren't Banks Lending

This figure from the Wall Street Journal shows the changes in bank lending for 10 of the 13 largest beneficiaries of the government's Troubled Asset Relief Program (TARP). The overall drop in loan volume has many politicians and taxpayers wondering what happened to the more-than $200 billion dollars spent in the first tranche of the bailout package.

There are a few basic reasons for the general tightening of credit. First, banks are still concerned about the deteriorating economic climate that could imperil even more of their assets. If these institutions face further write-downs (reducing the book value of their positions on their balance sheets) they will need TARP money simply to offset these losses. This process of "augmenting capital" is a way for banks to protect themselves against an uncertain future.

Second, banks used some of this cash to buy US treasuries and, in some cases, rival institutions. In effect, critics argue, the government provided cash for balance sheet "window dressing" (adding government bonds to the portfolio) and a slew of mergers and acquisitions (for which there was no financing on the open market). Bankers claim that these investments reflect their efforts to minimize risk exposure. As layoffs continue, lenders are worried about delinquent debt. Still, such behavior has fueled public skepticism about the Wall Street's motives.

There is, however, another reason that banks have pulled back on lending. Recent financial innovations have changed the way in which banks conduct business. Rather than simply accepting deposits and making loans, banks have increasingly embraced securitization. When banks securitize loans, they bundle up assets in their portfolio and sell them to investors, removing them from their own balance sheet. Until the collapse of mortgage backed securities, this strategy was an innovative was to minimize risk and still generate profits.

Here's where the banks got into trouble. The tranching of collateralized debt obligations (CDOs) allows investors to take different levels of exposure to default. More senior tranches are less risky, but have the lowest returns in the portfolio. The most junior tranche (known as the equity tranche) assumes the most risk, however, this class of CDOs can generate 15-20% returns. When banks securitized loans, they often sold off more senior tranches, but held the equity tranch so as to reap the benefits. During the housing boom, this strategy proved extremely lucrative.

Now these synthetic CDOs are squeezing banks at both ends. As housing prices fall and defaults increase, the tranches which banks are holding are the first to lose value. In addition, there are very few investors who want to buy bundled securities from banks, thus undercutting an important revenue stream for banks. In modern finance, banks don't lend to make interest, they lend to securitize. As a result, bailout packages that increase bank's capital reserves will not necessarily increase their loan volume.

It is misleading to say that banks have completely stopped lending. On the one hand, there are data that show otherwise. But more accurately, bank lending is a market-driven enterprise, where rates are determined by supply and demand. As banks become more fearful of defaulting loans, the rate at which they are willing to lend money rises (often prohibitively). Under these circumstances, even credit-worthy companies are facing a higher cost of borrowing.

Forcing the banks to lend will be a difficult, if not fruitless, task for lawmakers. As Congress calls for prudence and responsibility in the financial world, these institutions may argue that fewer loans are precicely in order. One thing is for certain, there has been no easy way to loosen the credit market.

Looking to Iran for Afghan Supply Routes

Early Tuesday morning, militants in Pakistan bombed a major supply route in the Khyber Pass, about 25 miles northwest of Peshawar. Roughly three-quarters of the supplies destined for NATO troops in Afghanistan are transported through this mountainous region, and the attack highlighted the need for alternative support routes. Pakistani officials said the destroyed bridge would take some time to repair, but a NATO spokesman said there was no risk of a supply shortage.

Most of the food, equipment, and fuel that is needed in Afghanistan first arrives at the Pakistani port in Karachi. These supplies are then transported to the Khyber Pass, where they are trucked through perilous terrain into the Afghan border town of Torkham. Over the past several months, insurgents have launched multiple attacks against the Khyber Pass supply route, hoping to disrupt the US-led mission against the Taliban. The region is part of Pakistan's Federally Administered Tribal Areas, known for heavy weapons and Taliban sympathizers.

As an immediate reprieve, NATO supplies will likely pass through a more southern crossing in Baluchistan, which connects the Pakistani town of Chaman with Kandahar in Afghanistan. Still there is mounting concern among NATO commanders that these routes are insufficient for supplying the mission in Afghanistan. President Barack Obama has signaled his desire to send three additional brigades to Afghanistan (some 10,000-12,000 troops) by mid-summer, and boost forces by another 30,000 in the next 12-18 months. Such an increase in the force level would demand massive logistical support, which the existing supply routes cannot sustain.

The US military is undoubtedly aware of these constraints. Last month, the chief of US Central Command, General David Patraeus, said that agreements had been reached with Russia and Central Asian states to secure new supply lines (though he provided few details). Other than neighboring Pakistan, the following countries share a border with Afghanistan: Turkmenistan, Uzbekistan, Tajikistan, China, and Iran. Regional ports include Georgian docks on the Black Sea or Turkmen docks on the Caspian Sea.

It would be difficult to imagine a list of countries and way-stations with greater diplomatic complications. All of these states are wary of the great political chess match between Russia and the West, and connections to NATO could upset the Kremlin. Few analysts suggest that Russia wants to disrupt the Afghan mission, but Moscow could extract major concessions from the Americans (regional influence) and Europeans (natural gas prices) alike. As a result, this week has seen a dramatic turn in US relations with another regional power: Iran.

On Monday, NATO's top military commander, US General John Craddock, said that alliance members were free to negotiate with Tehran. Not surprisingly, this announcement marks a considerable break from the preëxisting strategy in Afghanistan. In years past, American officials claimed Taliban insurgents were using Iranian weapons, however, the tone has dramatically changed since Mr Obama took office. While it is unlikely the US will use Iran's transport routes any time soon, NATO members with good Iranian relations could benefit from the alternative supply lines. Most analysts expect Germany, France, and Italy to use the Char Bahar port in southeastern Iran.

Route security is an important factor in promoting Afghan stability in the short term. Indeed, many of the additional NATO troops will be used to protect truck convoys, police major highways, and improve transportation throughout the country. These measures are essential in building the necessary infrastructure on which Western forces are hoping to build a viable state. Still, there are many political challenges to come. Any successful strategy in Afghanistan will have to incentivize rival factions to participate in some sort of power-sharing agreement.

In all likelihood, such diplomacy will require the inclusion of the Taliban or Taliban elements (as with Sunni insurgents in Iraq). During this delicate process, the Obama administration's negotiating skills will certainly be tested. Fortunately, the recent announcement on Iran shows a deft understanding of the realities in Central Asia.

At Lehman, What Bankruptcy?

This graph from Calculated Risk shows the deteriorating unemployment picture in the US. According to the year-over-year statistic, 2.6 million fewer Americans were working in December 2008 than December 2007. Still, many analysts predict these numbers will get worse before they get better. And yet...

In a remarkable story, the Wall Street Journal is reporting today that Lehman Brothers is actually hiring. The disgraced financial services firm has already recruited back more than 200 former employees, and is looking to add to its staff. On September 15, Lehman filed for Chapter 11 bankruptcy protection citing a bank debt of $613 billion, a bond debt of $155 billion, and net assets of only $639 billion. The event sent shock waves through the financial system, triggering the settlement of some $400 billion in Credit Default Swaps (CDS) and destabilizing the broader economy in the US and throughout the world.

As with the epicenter of any disaster, this collapse left plenty of debris. Indeed, Lehman's financial ruin will require a significant clean up effort. According to reports, Lehman still has 1,400 private investments valued at $12.3 billion and some 500,000 derivative contracts with 4,000 different trading partners worth about $24 billion. These obligations must be unwound in an orderly and timely fashion, if the firm is to dissolve within its stated goal of 18-24 months.

And so, Lehman is awash with resumes. The WSJ claims that many out-of-work Wall Street professionals are looking for any opportunity with a steady paycheck. Those who lost jobs at Citi, Bank of America, or other competitors, are now looking to join (albeit temporarily) the firm that accelerated the financial crisis. With so many derivatives and real-estate contracts still unsettled, it will take some time before Lehman can sell off all its remaining assets. In an embattled industry, it is a perverse form of job security.

Alvarez & Marshal, the New York restructuring firm that also worked with Arthur Anderson after the Enron collapse, is directing Lehman's clean-up. In an effort to raise cash, A&M have helped the firm sell its impressive contemporary artwork collection (reportedly for some $30 million) and part of its corporate jet fleet (more planes and a Sikorsky helicopter are still up for sale). Lehman also sold its glitzy 38-story office building in Midtown Manhattan as part of its desperation deal with Barclays. Lehman now has about $7 billion dollars, but needs to pay off $150 billion to its creditors. There is still a long road ahead.

The good news is that A&M has decided to manage some of Lehman's holdings rather than sell them into a depressed market. This move should provide some structure for the upcoming months of financial disentanglement and be more profitable than any sort of mark-t0-market scheme in the current environment. The bad news is that Lehman has a psychological effect on investors. The sooner the debris is cleared away, the sooner banks will begin their normal operations. Until Lehman's positions are settled and the entire bankruptcy experience has run its course, credit will remain tight and risk appetite will stay low. After all, no one wants to get caught in another CDS/bond trap.

For now, Lehman's hiring process will flummox (if not enrage) anyone living through this financial storm. But there is reason to believe that once these same jobs are lost, it will actually spell good news for the economy.