Stress Tests Are Not All They're Cracked Up to Be

Three months into the current administration, investors continue to struggle with the market surprises President Obama has created. An administration that is high on ideals yet light on details has steered us down many winding paths. The most recent is the bank stress test.

From the March lows, bank stocks have ignited the rally and then provided more fuel. As most have produced profitable quarters, we have a looming unknown on the horizon. Aiming to eliminate uncertainty and calm the markets, Treasury Secretary Geithner embarked on a highly public stress test. The goals were to determine how banks would perform under various credit shocks, determine how much incremental capital would be needed to withstand future expected losses, and then encourage those firms at risk to seek private capital as needed.

While the idea of providing transparency has merit, this process has been flawed from the beginning. Firstly, banks routinely stress their balance sheets, so to think that a Treasury-imposed test will unearth new information is naïve. Second, two large issues will prevent the data from being useful and effective-reality and credibility.

When deriving the parameters of the stress test, the Treasury had to walk a fine line. Creating a test that most banks fail will create panic. Make the guidelines too lenient and the test loses it power. Therefore, the Treasury needed to pick adverse scenarios, but none that were too strict. So what we ended up with is a middle ground where things appear bad, but never approach a truly awful state. The "more adverse" scenario assumes a peak unemployment rate of 10.3%. While this is distant from the current 8.5%, it is nowhere near how bad it could become. Such an approach allows most banks to pass and prevents panic. However, it may also leave us unprepared for future shocks.

The second issue deals with credibility. We all know the Treasury wants most banks to pass. However, a test that all pass would be deemed worthless. Therefore, at least one bank must fail. The idea of the test is to single out those banks in trouble and encourage them to seek private capital. However, I expect the failing firms to be viewed as so toxic by the marketplace that their shares will drop quickly and never recover.

Over the next two weeks, we have two dates to watch. On April 24, we will receive parameters of the stress test which will include assumptions about how the losses were calculated. Then on May 4, five trading days later, we will see the results. Expect those five days to be extremely volatile. Knowing that failing firms will see their share prices massacred, I expect a great deal of effort to be used in forecasting how the test assumptions will affect individual firms. Those who bet correctly will see massive gains.

Initially, I saw the stress test as benign. It was another meaningless idea from a group big on concept, yet light on details. Now I see it as something much worse. As first-quarter results have shown, banks are capable of using time and a steep yield curve to earn income and increase credit reserves. Such a combination will allow these firms to move beyond the mistakes of the past and resume a process of credit creation that allows the economy to grow. The key factor they need is time. By creating an impossible situation that cannot satisfy anyone, the bank stress test will increase uncertainty, heighten anxiety, and threaten the cautious balance in which we operate. As the market divides the winners from the losers, the action will get brutal and ultimately all banks suffer.

Comments

[Roger Knights:]

Typo: Use "They're" in:
"Not All Their Cracked Up To Be"

Apr 22 03:25 PM

[BigJake:]

so is it a better idea to keep pumping taxpayer money into black hole institutions just to keep the market happy?

Apr 22 03:26 PM

[Stewie:]

The question I have about the stress test is are the banks using unemployment data at the national average or are they being tested using data in their footprints. If you do business in Ohio, Indiana, Michigan, etc you are likely to far surpass the 10.3 disaster rate. Some of the large mid-west regionals could be in real trouble.

Apr 22 06:58 PM

[doubleguns:]

Geithners pandora's box.

Apr 23 05:07 AM

[Allan Frain:]

"As the market divides the winners from the losers, the action will get brutal and ultimately all banks suffer."

Please !

This statement suggests that despite all the bailouts, Banks are still too exposed to market forces. What all banks "suffer" from is 41% of all corporate profits, a subsidy roughly equal to annual GDP, and continued dominion over our Congress and Administration.

Apr 24 08:41 AM

[Paul_L:]

Financials went up a bit after methodology was published today, strange. They drove this market up and have looked unstoppable although there were articles on converting goverment preferreds to commons. seekingalpha.com/artic... has an excellent article on which firms might need more capital.

Apr 25 01:23 AM