Demystifying the Stress Tests

The Federal Reserve released details about the methodology of the "stress tests" conducted on 19 banks with assets exceeding $100 billion, including Bank of America Corp. (BAC), Citigroup, Inc. (C), JPMorgan Chase & Co., Inc. (JPM), Wells Fargo & Co. (WFC) and PNC Financial Services (PNC). These banks collectively hold two-thirds of the assets and more than one-half of the loans in the U.S. banking system.

Overall, there was very little of substance in the White Paper that had not been released previously. The White Paper stated that "most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized," but given the uncertainty around the future course of the U.S. economy and potential losses, it would be prudent for these banks hold additional capital "to provide a buffer against higher losses than generally expected."

We would note that there are well over 7,000 banks in the country, and the paper did not say that most of the big 19 were well capitalized. The statement that most banks are well capitalized may therefore fall into the "true but trivial" category.

The results are being shared with the respective banks, and the final capital assessment will be disclosed on May 4, 2009.

According to the methodology adopted, the banks were asked to estimate their potential losses on loans, securities and trading positions as well as off-balance-sheet items and revenue, and the resources available to cover these losses under two alternative macroeconomic scenarios -- only one of which should really be considered.

The baseline assumptions for real GDP growth, the unemployment rate and housing prices decline for 2009 were -2.0%, 8.4% and 14%, and for 2010 they were 2.1%, 8.8% and 4% respectively. For the more adverse scenario -- real GDP growth -- the unemployment rate and housing prices decline for 2009 were -3.3%, 8.9% and 22%, and for 2010 they were 0.5%, 10.3% and 7%.

Looking at the assumptions vis-à-vis the current state of the economy, we think that the more adverse scenario looks more probable in the case of real GDP growth and housing prices decline, while the unemployment rate still looks too optimistic in the more adverse scenario. In other words, the baseline scenario should be disregarded entirely when looking at the results for the individual banks when the information is released.

The assessment submitted by the banks were then reviewed and assessed by the supervisors, and it was then ensured that the firms’ projections were also consistent with accounting standards and proposed changes to accounting standards. To determine the capital Adequacy, the regulators looked at various measures including (but not limited to) pro forma equity capital and Tier 1 capital, and a measure close to Tangible Equity Capital.

We anticipate banks' shares to remain volatile between now and May 4, as there will be speculation on which banks will emerge as well-capitalized and which ones will need additional capital. As we have seen in recent results declared by the banks, the losses have been rising sharply, and if a meaningful and fair exercise has been conducted by the regulators, then we suspect that at least some of these banks will be found to be in need of additional capital.

Comments

[Robert Perrego:]

well the only thing less revealing than the release was this discussion of the release.

"We anticipate banks shares to remain volatile between now and May 4, as there will be speculation on which banks will emerge as well-capitalized and which ones will need additional capital. As we have seen in recent results declared by the banks, the losses have been rising sharply, and if a meaningful and fair exercise has been conducted by the regulators, then we suspect that at least some of these banks will be found to be in need of additional capital."

no kidding.

the only other option is that nothing at all happens as every bank passes.

Apr 24 05:29 PM

[mac123449:]

Looks like the government has a plan with this new possible pandemic of flu starting in mexico. if enough people die that means more jobs for everyone else. might actually be good for stocks if it starts going into full fledged pandemic mode like flu of 1918 did.

Apr 24 06:34 PM

[tedfoo:]

I saw no good news in the stress test pre-release. If anything, the more adverse scenario is the more likely. There is more economic trouble ahead. What is to become of the economy if/when chrysler and gm go chapter 11? The ripple effect was feared 4 months ago, but no longer matters, does it?

This stress test was very low stress, and more akin to a forecast. It was a study on what the banking system will need to survive 6 months from now, provided the economy continues to stabilize at forecast rates.

So why did the government do this "stress" test? I think, they needed to know if a bank is going to need more money now; while there is still time to raise it in the private equity markets. The govt knows if the banks start to teeter on failure again, coming back to congress with the "too big too fail card" was not going to get anywhere. The public is willing to let these banks fail now, and that would be financial disaster.

I see the writing on the wall. The banks are still very sick. The govt knows this, but I think they have the foresight to try to dupe more private equity into this mess before it's too late to do so. Seeing that the financial stocks continue their climb, clearly the plan is working.

Apr 24 07:14 PM

[marketman54:]

Who cares what the government reports! They are going to sugar coat everything so that the market doesn't collapse!!

Look, these are the banking problems:

1. Existing toxic assets and their negative value.
2. As unemployment continues to steadily increase there will be more mortgage defaults; credit card payment defaults; car loan and car lease payment defaults.
3. Commercial real estate defaults will begin hitting the banks big in the next three months.
4. Small and medium sized businesses are failing everyday and more will be defaulting on their loans.
5. The business climate is so bad banks don't want to lend money.
6. The banks get to practice VOO DOO accounting so who knows what is really going on.
7. There is absolutely NO CLARITY in the financial system!

Let's just say that logic plays no part in items #1 thru #5. When you get to change accounting practices to make your company look good and then the government comes out and tells you nothing - I think that this is plenty of reason to panic!

Lets hope the analyst jump all over the stess tests when they come out for the 2nd quarter!

Apr 25 07:48 AM

[Rumpole:]

The whole stress test thing is an exercise to try to instill confidence in the financial system. Like the Prez has been saying, it's about confidence. However, to the government it doesn't matter if that confidence is based on fiction.
It would be no disaster for the banks to fail. it would be a disaster for some, but for others it would be a tremendous opportunity. And it would allow a new system to be formed from the ashes that has a stronger basis. You know, like the proberbial phoenix rising.

Apr 25 04:35 PM

[User 357705:]

Demystifying the so-called stress test is quite easy! Its pure unadulterated bovine excrement designed to give the appearance that those "in charge" are "doing something".

Apr 26 01:49 AM

[sticktoitiv...:]

mac123449

How idealistic of you. Okay, maybe not. But the back plague did usher in the Renascence.


On Apr 24 06:34 PM mac123449 wrote:

> Looks like the government has a plan with this new possible pandemic
> of flu starting in mexico. if enough people die that means more jobs
> for everyone else. might actually be good for stocks if it starts
> going into full fledged pandemic mode like flu of 1918 did.

Apr 26 04:01 AM