Via John Carney at Clusterstock, we have a study by Harvard’s Joshua Coval and Erik Stafford and Princeton’s Jakub Jurek, who concluded that Treasury Secretary Timothy Geithner’s assumption regarding the “inherent economic value” of toxic assets is bogus:

The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals. A structural framework confirm…s that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased. The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing.

In short, the toxic assets clogging up the banks are worthless, and not, as Geithner believes, stuck at a depressed value due to our lousy economic climate. This is a problem because Geithner’s entire bank rescue plan hinges on the notion that these assets are worth something. If that notion is wrong, then the plan will, at best, “simply fizzle,” and at worst, be a very expensive subsidy to savvy investors that does nothing to relieve banks of their toxic waste.

Like Nouriel Roubini, Coval, Stafford, and Jurek believe that “many major US banks are now legitimately insolvent.” Therefore, they write, “any taxpayer dollars allocated to supporting these [toxic asset] markets will simply transfer wealth to the current owners of these securities”:

To the extent that these assets reside in banks that are now insolvent, the owners are essentially the bondholders of these banks. The reason their bonds are currently trading far below par is that the assets backing up their claim are just not worth enough (nor expected to become worth enough when their bonds mature) to repay them. And so while they will be cheered by any government overpayment for the toxic assets backing up their claims, their happiness will be at the taxpayer’s expense since, to the extent that current prices are fair, they will be receiving more than fair value for their investments.

As more and more holes get blown in Geithner’s plan — and more banks evince a willingness to twist the bank rescue on its head — one wonders if nationalization is getting any more consideration.

The Wall Street Journal reported today that “top federal bank regulators plan to meet early this week to discuss how to analyze the results of stress tests being conducted on the country’s 19 largest banks.” Analyzing these tests will be a key moment in the battle to save the U.S. banking system, as the tests could confirm the insolvency of several large institutions.

With that in mind, it’s worth asking just how stressful these stress tests are, and whether they’re really going to show us anything about the banks that we didn’t already know. First, here’s what the tests entail:

Regulators designed the stress tests to ensure that banks could survive — and continue lending — even if the unemployment rate were to rise above 10% and home prices to fall by an additional 25%. The tests, which were conducted largely by economists and experts using mathematical models, seek to determine whether a bank would need more capital to continue lending under such circumstances.

Considering that unemployment is currently at 8.5 percent, and Moody’s Economy.com has predicted that home prices in some areas will fall by nearly 18 percent, the scenario laid out in the stress test seems pretty plausible, and not at all a worst-case scenario. There is also a “delayed time bomb” sitting in the housing market, as Alt-A (one notch above sub-prime) and Option-ARM “teaser” mortgages are poised to reset in 2009 and 2010, potentially wreaking further housing havoc.

Maybe that’s why William Black, a former senior bank regulator and S&L prosecutor, told Tech Ticker that the stress tests are “a complete sham” that don’t go far enough:

“There is no real purpose [of the stress test] other than to fool us. To make us chumps,” Black says. Noting policymakers have long stated the problem is a lack of confidence, Black says Treasury Secretary Tim Geithner is now essentially saying: “’If we lie and they believe us, all will be well.’ It’s Orwellian.”

As Dean Baker noted, “a stress test is supposed to examine a worse case scenario, not an optimistic one. By picking overly optimistic projections, Treasury increases the likelihood that banks will pass the stress test.”

The weakness of the stress tests may be further compounded by the recent decision to relax mark to market accounting rules, which could increase opacity and uncertainty about the value of toxic assets. If the banks are able to pretend that their assets are worth more than they really are, and the stress tests don’t push the banks to prove they can be solvent in the face of further economic deterioration, then as Felix Salmon noted, we may be “rubber-stamping utterly unrealistic [bank] balance sheets.” And that would be simply punting the problem down the road, while allowing zombie banks to continue lurching around the economy.