Sunday, May 3, 2009
Executive Summary
- The bank stress tests are a sham.
- Reality is already worse than the worst case stress test scenario.
- The stress test results will be used as a “positive indicator” anyway.
- Don’t fall for it.
The bank stress tests, the results of which are to be announced later this week, have already failed. Why? Because the stress test is supposed to assess how a bank’s loan portfolio would fare under a variety of scenarios, but reality is already far worse than the worst-case scenario. The FDIC, Treasury, and Federal Reserve went ahead with their weak input assumptions to conduct the stress test, even though they knew that reality was outpacing their most dire scenario.
In other words, the stress test is a sham.
Think of it this way: Suppose someone asked you to assess how many cars out of a hundred would survive a drive from NYC to LA and back. You’d probably start with some simple questions about the age of each car, their past histories of mechanical difficulty, and the driving conditions. Now, suppose that after you’d made your best guess, it turned out that the cars had to drive the entire way on dirt roads, not highways, and in winter. You’d want to change your estimate, right?
Not the FDIC or the Treasury Department. They want to stick with their “stress test” results, even though conditions have worsened considerably since the stress tests were designed. In our analogy, banks are now driving on dirt roads in winter, but the Treasury and the FDIC, with great fanfare, will announce how those banks would perform if they were driving on highways in early summer.
My prediction: The stress tests will reveal that everything is mostly okay. For appearance’s sake, a few banks will be shown to need a modest amount of capital, but this is only because the Treasury doesn’t think it can get away with simply proclaiming that everything is 100% good at every bank.
As always, the devil is in the details. Let’s peer in.
First, let’s discuss the purpose of the “stress tests.” As the name implies, the idea here is to concoct a number of economic scenarios and apply them to each bank’s portfolio of assets to assess how that bank would perform under each circumstance.
by davos