On February 10th Treasury Secretary Geithner announced his much anticipated plan to solve our financial crisis.  The proposal was a total disaster.  Critics observed that the announcement contained little detail and the stock market reacted with deserved pessimism.  Geithner promptly disappeared from the public eye to lick his wounds.

The one noteworthy detail disclosed was the creation of a uniform “stress test” to be applied to banks that receive Federal money to see if the recipients have the financial strength to survive the ongoing meltdown.  Common sense dictates that such an analysis be performed prior to writing the check, but so be it.

The proposal was designed to create the impression that the Federal Government was proactively dealing with the financial crisis.  This initiative was noteworthy, though, not in that it was new or constructive, but in that it was a veiled admission of Federal regulatory incompetence.

Along those lines we have an excerpt from a Bloomberg article released today detailing the methodology behind the stress tests.  In reference to the banking regulators’ performance during the past several years:

“There was a heavy assumption” that soaring loan defaults in recent months were caused by the recession, said Kevin Petrasic, who served at the Office of Thrift Supervision from 1989 to 2008.

The official’s remarks provide insight into the release April 24 on the regulator’s methodology for the tests. Supervisors are addressing an error made two years ago when basing foreclosure projections on economic assumptions and are now concluding that poorly written loans may default regardless of the economy’s performance.

This is enlightening.  Bank regulators were effectively ignoring the underwriting standards behind a loan, which ensured that foreclosures would occur, in favor of macro economic projections.

This brings us to the Geithner announcement.  Stress tests are not a new idea.  All banks are by definition subjected to stress tests on a recurring basis.  Banks can not exist outside of clearly established operating parameters dictated by the Federal Government.  Banks are further required to submit detailed quarterly reports which effectively function as stress tests.

For the government to feel it necessary to perform additional stress tests to measure the future viability of these banks is an admission that the banking regulators have failed miserably in performing their only duties.  I for one would not have so publicly and enthusiastically drawn attention to this failing.

Additionally, Geithner has drawn attention to the new, discreet analysis.  According to recent leaks, the results of the stress tests were much worse than the banking regulators expected.  Shocking I know. 

So now what?  Releasing the negative results will further erode confidence in these institutions and our banking industry.  In an effort to obfuscate this reality, the Government has already started discussing the possibility of nationalizing these troubled banks by converting previous TARP investments into common equity.

Nationalization is not a good solution, nor is it one to be entered into without due consideration.  But Geithner’s stress testing may have forced the Government into making another rash decision by demonstrating the failure of the regulators and focusing attention on a banking industry which as it turns out is even weaker than we had been led to believe.