The latest leak, arriving curiously after the markets closed, is that the Treasury wants Citigroup to raise $10 billion as a result of the famed stress tests, which the bank is fighting tooth and nail. Another rumors circulating in the media Is that Bank of America is being asked to convert $45 billion of preferred to common. Wells Fargo has been fuming in public since the tests were announced, but so far I haven’t seen any detail on the indignities to which they think they are being subjected.

Let’s recap. On the one hand, the stress tests aren’t turning out to be the complete farce that I had thought they might be (my benchmark was whether Citi got off clean while some regional banks, such as Fifth Third, were dinged to validate the process). But that comes well short of being sufficient. Consider:

1. The adverse case in the scenarios is far from the worst reasonably conceivable, so the “stress” is too favorable to the industry 2. The banks submitted results using their own methodologies, and most important for the big capital markets players like Citi and Bank of America, their own risk models. In my view, the biggest single error of the Greenspan era wasn’t the famed “Greenspan put” but his complete hands off posture concerning derivatives. Not only did he adopt a “let a thousand flowers bloom” stance, but allowed banks to adopt their own risk models, and did not require Fed staffers to develop sufficient competence to evaluate them. Mr. Market knew best. The inability to look under the hood and assess risk models and practices, except at a very superficial level, is an enormous failing and hamstrings the effort underway now. 3. There was no verification of underlying accounting and loan books, not even a teeny bit of sampling.

With this as background, the “stress test” process was awfully industry friendly. Yet some were nevertheless singled out for action, and they are protesting bitterly. That in turn suggests:

1. Even with a liberal grading scale, some banks are still pretty punky. I am wondering if Treasury is surprised. I suspect the hope was that Treasury would draw the line in such a place that the banks would look more or less OK, with only minor remedial action required. Team Obama has made it clear that it is not up for nationalization, yet results like this are a reminder that this outcome may be foist upon them (we think it’s a given for Citi unless it dismembers itself instead). 2. The fact that Treasury is letting the banks negotiate the outcome means: It isn’t hugely confident in the results, and/or It is still a hostage of the anti-regulatory logic of the last twenty years. A regulator with any guts would not take backchat from its charges on a determination of safety and soundness.

One also had to wonder whether Citi, in conjunction with trying to persuade Treasury that it is in rude health, is hinting at the danger of precipitating a run on the bank. Citi’s roughly $500 billion in foreign deposits are a huge impediment to putting the bank into conservatorship. It seems inconceivable that Uncle Sam would guarantee those deposits, yet failure do so could have catastrophic consequences. A run with that much in the balance would be beyond the big bank’s ability to satisfy on any short-term timetable (even its now large Treasury holdings are below that level, and dumping any asset type on that scale to pay off depositors would roil markets).

So bizarrely, Citi holds a sword of Damocles over the Treasury, much as AIG does. And that means the problem of dealing with Citi if it is indeed not the best shape, is tantamount to disarming a nuclear warhead without an instruction manual.

The Wall Street Journal story on the continuing soap opera contained some interesting tidbits:

The Obama administration is expected soon to outline what type of investor it will be in companies where it has a stake, according to people familiar with the matter. The Treasury is discussing applying different levels of governance depending on the size of the U.S. government’s stake. The overall goal is to get out of the investments as quickly as is possible and minimize government intervention in banks’ operations. The outcome of the stress tests could play a major role in shaping the next phase of the U.S. government’s intervention in the nation’s ravaged financial system. After the results, banks will have 30 days to give the government a plan and six months to put it into effect. The banks are expected to reveal their plans next week.

We’ve been grumbling for some time that the automakers have been raked over the coals, presented with strict deadlines for plans proving their viability, while the banks have gotten off close to scot free, save demands for restraints on pay (which given that they are wards of the state, seems not at all unreasonable, despite the howls of protest from supposed capitalist employees having trouble adjusting their lifestyles to the new reality. And don’t give me the talent argument. Yes, some are defecting to boutiques, but time will tell if they can be as successful as they think in the “eat what you kill” model). One presumes these plans are mere fundraising plans, not operational plans, and thus will be far less demanding that what GM and Chrysler faced.

This comment was a useful reminder:

The stress tests are a central part of the Obama administration’s effort to restore confidence in the U.S. banking system.

While this may be shorthand, it reveals a preference for optics over substance. The priority should be to assure depositors and investors that banks are sound, not to “restore confidence”, a more nebulous and subjective standard.