Cake decoration by Ryan Hettena, age 3.

On Feb. 10, shortly after Timothy Geithner announced that the government would perform “stress tests” of major American banks, the U.S. treasury secretary was asked what amounts to a trillion-dollar question. Well, at least at half-a-trillion.

“Do you think that are largest banks are insolvent?” Sen. Jim Bunning, R-Ky. asked Geithner later that day. “What will you do if your stress test of major banks reveal that they are insolvent?”

The New York Times’ Dealbook blog published the results of an two-year, independent bank stress test:

CreditSights ran the numbers, and found that according to its “severe” case situation, all the major banks and brokerages — Citigroup, Bank of America, Wells Fargo, JPMorgan Chase, Goldman Sachs and Morgan Stanley — might require further capital injections from the government….

The future losses for some banks are staggering by CreditSights’ estimates: Wells Fargo, $119 billion; BofA, $99 billion; JPMorgan, $124 billion; Citi, $101 billion; Goldman Sachs: $47 billion; Morgan Stanley, $34 billion.

To put these numbers in context, consider the market capitalization of these companies: Wells Fargo, $67 billion; BofA, $36 billion; JPMorgan, $92 billion; Citi, $19 billion; Goldman Sachs $44 billion; Morgan Stanley $25 billion.

In other words, the owners of the banks (shareholders) have not invested enough capital to cover the potential losses in assets in most cases.

Guess what that means! If the worst comes to pass, America’s biggest banks are effectively nationalized! Only the government can cover losses of that magnitude.

The sooner we wake up to this fact, the sooner we can move forward.

Andrew G Haldane, Executive Director for Financial Stability, Bank of England: 

Back in August 2007, the Chief Financial Officer of Goldman Sachs, David Viniar, commented to the Financial Times: “We are seeing things that were 25-standard deviation moves, several days in a row.”

To provide some context, assuming a normal distribution, a 7.26-sigma daily loss would be expected to occur once every 13.7 billion or so years.  That is roughly the estimated age of the universe.   A 25-sigma event would be expected to occur once every 6 x 10124 lives of the universe. That is quite a lot of human histories.

When I tried to calculate the probability of a 25-sigma event occurring on several successive days, the lights visibly dimmed over London and, in a scene reminiscent of that Little Britain sketch, the computer said “No.”

Fortunately, there is a simpler explanation – the model was wrong.

Testifying before Congress today, DNI Dennis Blair said “the primary near-term security concern of the United States is the global economic crisis and its geopolitical implications.”

Time is probably our greatest threat.  The longer it takes for the recovery to begin, the greater the likelihood of serious damage to US strategic interests…. Although two-thirds of countries in the world have sufficient financial or other means to limit the impact for the moment, much of Latin America, former Soviet Union states and sub-Saharan Africa lack sufficient cash reserves, access to international aid or credit, or other coping mechanism.  Statistical modeling shows that economic crises increase the risk of regime-threatening instability if they persist over a one to two year period.

Congressional Budget Office on the stimulus bill:

In contrast to its positive near-term macroeconomic effects, the legislation would reduce output slightly in the long run, CBO estimates, as would other similar proposals. The principal channel for this effect is that the legislation would result in an increase in government debt. To the extent that people hold their wealth as government bonds rather than in a form that can be used to finance private investment, the increased debt would tend to reduce the stock of productive private capital. In economic parlance, the debt would “crowd out” private investment. (Crowding out is unlikely to occur in the short run under current conditions, because must firms are lowering investment in response to reduced demand, which stimulus can offset in part.) CBO’s basic assumption is that, in the long run, each dollar of additional debt crowds out about a third of a dollar’s worth of private domestic capital (with the remainder of the rise in debt offset by increases in private saving and inflows of foreign capital).