Nineteen major banks worth more than $100 billion will face a mandatory “stress test” to judge whether they have enough capital to survive another steep drop in housing prices or a sharp increase in unemployment rates.

Those that fail would have six months to raise money from the private sector, or would receive additional capital injections from the government in the form of securities that could be converted into common stock at a 10 percent discount to the price before Feb. 9.

What does the US Treasury expect to find when it looks through the microscope of its stress test? With just the existing regulatory reviews of banking (FDIC, OTS, OCC), insolvency of the system is apparent. When you add to this borrowers’ creditworthiness will continue to erode because of job losses and bank asset values will erode because borrowers will default at higher rates, it begs the question – what are we stress testing dead banks for?

With the information already available we know that reconstruction and reform are the next requisite steps. What basis is there to believe a hastily constructed set of assumptions applied to a historic bank testing model wielded by a federal government that did not see the problem in banking build for five years, will reveal any newly meaningful and sage data? Or that it will then be interpreted sagely by the same staff that did not see the original problem?

Details of the test can be heard in this PBS News Hour podcast with Secretary Geithner.

In addition to the testing, there is the public comment that a failed stress test would require the institution to raise private capital (i.e. investor capital). This ignores that banks are having their existing base of investor funded capital run-off to zero in the markets because the Treasury has not stepped in and provided definitive support for the safety and security of current debt & equity holders. There is no new investor funded capital to get, now or after any stress test, when there’s a hole in the bucket they’re being asked to invest in.

There needs to be some frankness and honesty from Treasury regarding the state of affairs in banking. Secretary Geithner often refers to the the loss of confidence in his interview. He emphasizes the devastating effect it has on credit flow and how it must be restored.

This does not address what’s wrong with banking - its balance sheets. Banks aren’t in trouble because of fair value accounting or confidence in counterparties. These are symptoms. They’re in trouble because of value erosion in their financial assets. And value is eroding because asset prices recorded on banks’ balance sheets reflect prices determined by debt spending fueled by the myth of wealth as portrayed by unrealized gains formed over a decade (consumer investments and housing).

The demand curve has changed permanently. The unrealized gains have vanished but the debt remains. Value has to erode until it reflects prices that consumer’s wages can pay for the assets, as well as the debt they accumulated. Bank balance sheets are in a state of correction and that is resulting in banking’s insolvency - they owe more than they can recover on their assets (again there are many banks that aren’t insolvent - but so many of their counterparty banks and financial trading partners are that they could not recover the values on the their own balance sheets and likewise all through the chain).

The thing left to do with the debris that passes for banking is to reconstruct it. Establish a bridge operating architecture that assures credit flow sufficient to stabilize economic output through federally issued minimum operating guidelines and liquidity support (a bank can exceed these operating guidelines if it so decides and can support the practice). Continue to utilize all current institutions, their operating personnel and business relationships in their current form, as long as their balance sheet warrants. Charter and staff a temporary federal agency under the premise of the original Reconstruction Finance Corporation from 1933 (also puts lost of recently unemployed finance and business professionals to work).

This agency would be the clearing house for foreclosures, mortgage and asset backed securities and related damaged assets on a much larger and more credible scale than the original TARP idea of asset purchases. The agency is dissolved when the process is complete. This is not nationalization. Debt & Equity doesn’t get wiped out unless it would have under routine FDIC practice. I have experience in the RTC model of the 90’s. Does what it’s supposed to. The RTC did experience inefficiencies in asset redistribution but they can be eliminated through competent management of the model.

Failing institutions with materially underwater balance sheets would be either dissolved directly and their assets redistributed (as is the current routine practice of FDIC and OTS for failed banks) or placed in a 180 day operating conservatorship, where their balance sheet would be purged and cleaned and then the institution would be returned to normal service. Any federal official thinking this will take too long or too many resources or cost too much joins the cast of financial illiterates. It’s all they’ve left themselves in the tool box by not recognizing what has already happened to banking and acted on it.

There were a few years where everyone could buy & sell houses with no regard for their relationship to incomes and borrower’s means to repay them. This is the lag between the action and the reaction. The same holds for banking reform. Congress and the new White House can dilly dally for a while longer before the piano falls on our head and then there is more trouble than can be contained by all the money the Fed can print.