A Primer on the Bank Stress Tests

Posted by: Diane Brady on May 8, 2009

Everyone is racing to decipher the results of the so-called stress test on banks. Some are pleased; others are pessimistic. Here are some of the basic questions I’ve heard, and some thoughts:

What exactly is the ulterior motive of doing this stress test?

Technically, the tests are meant to give the public (especially the investing public) some much needed clarity on the actual health of the U.S. banks. On that level, it’s extremely useful. Until now, regulators have been talking about “the banks” as if they were some street gang rumbling through the economy. Actually picking out the weak from the strong is helpful.

But Treasury Secretary Timothy Geithner has also been looking to restore faith in the banking system through these tests, and assure the markets that the worst-case scenario is actually not so bad. That mission has some people questioning whether the stress tests were in fact tough enough.

Were the assumptions realistic?

The people I have spoken to say that, at the very least, they’re not exactly wildly pessimistic. Yes, the government has assumed a higher default rate on bank loans than what took place during the Great Depression. But that’s hardly surprising when you consider how loans were dispersed like candy in recent years.

What struck me was that the worst-case scenarios being tested don’t sound all that far-out. Consider, for example, that the government assumed a worst case of unemployment averaging 8.9% this year. Just this morning, the U.S. Labor Department reported that the rate in April was 8.9%. As for the assumption that unemployment will rise to 10.3% next year? Managers we’ve spoken to pretty much all assume the rate will be in the double-digits as companies rarely start hiring until their own fortunes are clearly on the rise.

How should people interpret the results?
Of the nation’s 19 largest banks, which control about two-thirds of U.S.deposits, nine got a clean bill of health. The other 10 have been ordered to raise a combined $75 billion. Hurray! But wait a second. The government also says there could be close to $600 billion in bank losses ($599 billion, to be exact, but what’s a billion these days?). Is $75 billion enough? Independent banking analyst Bert Ely, who joined me this morning on The Brian Lehrer Show (WNYC) about this topic, suggests it’s not.

What do these results say about the management of these banks?
To start, I was struck by the seeming lack of due diligence that some of them did. What does it say about State Street that 23% of its corporate loans could possibly default? Or Morgan Stanley, which may see 45% losses in its commercial real estate loans. Everyone now knows that many of the banks were liberal in issuing easy credit (the word ‘pinata’ comes to mind). Now that, say, Ken Lewis of Bank of America is overseeing an institution that’s estimated to face up to $137 billion in losses and needs $34 billion in capital, will investors clamor for a fresh face at the helm?

Four years from now, where will we all be?

Four weeks from now, the banks will have to present their plans for getting that fresh capital from new stock, asset sales or more government involvement. Four years from now, many expect that there will be new regulations in place to reduce “excessive” leverage and try to prevent all of this from happening again. Banks will no doubt be cautious for a while about lending, especially with so much focus on having a healthy cushion of capital.

But let’s not forget that much of silly stuff—loans without collateral and such—took place outside the official banking system. Nobody was dabbling in credit default swaps during the Depression. Innovative financiers will no doubt come up with new products to hedge risk and disperse capital. And law-makers, not to mention investors, will race to keep up.

 

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