Most Banks Will Pass, But Does the Stress Test Fail?

The Geithner Treasury team finally unveiled the details of its Stress Test methodology Friday (see Supervisory Capital Assessment Program). We will have to wait a few more weeks for the results. Based on early returns, the results are all but a foregone conclusion - most banks will likely pass with flying colors.

So in the absence of meaningful outcomes from the Stress Test, we might be better served by deconstructing the process itself. In this way we can better determine what it might mean for a bank to pass or fail, better assess the results to sensitivity in the data, and ultimately, determine whether the test itself even made any sense.

So what can be made of the process?

It has recently been argued that the “more adverse” scenario should actually have been the baseline (see Stress Test Scenarios or Stress Testing the Stress Test). I agree wholeheartedly. It has been clear for a while now that the Treasury’s scenarios did not adequately reflect economic reality. There is even some evidence that the economy has already deteriorated to a point where it is currently worse off than the “more adverse” scenario.

That point notwithstanding, there were two other details about the methodology (among others) that raise some concern.

First, from p. 4 of the official Stress Test document:

The BHCs [bank holding companies] were asked to estimate their potential losses on loans, securities, and trading positions, as well as pre‐provision net revenue (PPNR) and the resources available from the allowance for loan and lease losses (ALLL) under two alternative macroeconomic scenarios.

My comment: So if I understand this correctly, the Treasury is relying on banks to provide them with an assessment of their current troubles. This is like asking an alcoholic if he thinks he has a problem.

Second, on p. 3 of the document, the Treasury points out:

The economic value of loans in the accrual book is reduced through the loan loss reserving process when repayment becomes doubtful, but is not reduced for fluctuations in market prices, which may be driven by market liquidity considerations… As a result… the results of this exercise are not comparable with those that would evaluate such assets on a mark‐to‐market basis.

My comment: So here we are again in a mark-to-fantasy kind of world, where banks (which possess asymmetric information about the true quality of their underlying asset portfolio vis-a-vis the Treasury) might be able to favorably adjust the value of their assets. In my opinion, the best assessment of the underlying value of the assets on the books is what the market is willing to pay for those assets. The Treasury’s approach, in my opinion, leaves too much room for banks to claim, “It’s a liquidity problem.”

All this begs the question: While most banks will pass, does the Stress Test fail?

Disclosure: No Positions

Comments

[Moon Kil Woong:]

Yes. This stress test started out as a joke and is ending as one.

It is exactly like an English teacher giving their students (who they want to show are doing good) a grade without explaining why they gave them that grade and with no corrections. Furthermore, the student's were allowed to black out 50% of their paper in which the teacher is required to believe that the 50% blacked out was done without any errors.

I have a simple question, since when did government agencies have a right to spend millions on a project and restrict anyone from disclosure of it? Do they think they are divorced from the government like the Federal Reserve? If I was the media I think I would be delinquent in my duties unless I immediately filed for a Freedom of Information request on the data. Unless it is an issue of national security, I don't see why it shouldn't be disclosed. After all, the banks were allowed to make up (submit) whatever data they wanted to in the first place.

And if it is a national security issue then thinks are a lot worse then even Dr. Doom would surmise.

Apr 26 06:01 AM

[morph366:]

The government's approach should best be seen as one of delaying and circumventing the lack of liquidity issue.
You say that "the best assessment of the underlying value of the assets on the books is what the market is willing to pay for those assets." As we all know now the price that the market wants to pay is unacceptably low from the bank's point of view. And since the case for extending the public sector safety net (another euphemism for claims on future taxation) is becoming harder to make the only alternative is for the government and banks to somehow "muddle through". This is the real purpose behind the Stress Tests, PPIP and the changes in the FASB rules and the hope is that with enough distractions and obfuscation the problem will heal itself.

Convinced? nor am I.

Apr 26 06:24 AM

[wasabi:]

hey woong, what do you think is going to happen in the market this week? up or down?Do you think CIT will rebound?


On Apr 26 06:01 AM Moon Kil Woong wrote:

> Yes. This stress test started out as a joke and is ending as one.
>
>
> It is exactly like an English teacher giving their students (who
> they want to show are doing good) a grade without explaining why
> they gave them that grade and with no corrections. Furthermore, the
> student's were allowed to black out 50% of their paper in which the
> teacher is required to believe that the 50% blacked out was done
> without any errors.
>
> I have a simple question, since when did government agencies have
> a right to spend millions on a project and restrict anyone from disclosure
> of it? Do they think they are divorced from the government like the
> Federal Reserve? If I was the media I think I would be delinquent
> in my duties unless I immediately filed for a Freedom of Information
> request on the data. Unless it is an issue of national security,
> I don't see why it shouldn't be disclosed. After all, the banks were
> allowed to make up (submit) whatever data they wanted to in the first
> place.
>
> And if it is a national security issue then thinks are a lot worse
> then even Dr. Doom would surmise.

Apr 26 06:35 AM

[guitoon:]

stress tests are just plain smoke...perhaps just intended to pump a little more the financial sector.
It seems on friday the banks with a TCE > 4% rallied.
Well, I will not bet on this with the accounting gambling nobody knows what to trust.
I rode somewhere WaMu failed with a TCE of 7%.
Let's wait and watch the results on May 4th...last rally for financials ?? or start of the so expected pull back ??
Welcome to Wall Street casino

Apr 26 08:03 AM

[fireball:]

wouldn't a proper test be a print out at the end of the day just like a broker page. instead they say i bought bhp at $75, it is now under $50 but it should really be worth its all time high around a hundred. in a few years it will be that way, maybe.
it is ridiculous. once agan the citizen lives by one set of laws while the elitists live by a relax where required set of "guidelines". the constitution is just a pesky piece of paper that imposes limitations on the "goodfellas" and that annoying bill of rights must be outdated or something.

Apr 26 08:58 AM

[User 353732:]

People have observed that deception often precedes bankruptcy, financial, moral and policy. The higher the stakes for the favored and powerful few, the greater the prevarication.
The stress tests are a political disinformation campain aimed at a confused, fearful and increasingly resentful citizenry. They are not designed to cater to or convince most of people who frequent SA.
The campaign is succeeding.
The objectives, it might be surmised are:
1. We, your rulers, knew what we were doing
2. See, we were and are right
3. We always know what we are doing and we are always correct because we simply know better
4. Now run along and no more questions ; we are too busy fixing all the problems, You the People created.

Apr 26 09:31 AM

[Ergo:]

It seems to be that "test" is the right word, since apparently, everyone will be graded on a curve. ;-)

Apr 26 09:40 AM

[ArkansasAngie:]

What does it mean to the economy -- the market -- you and me when the FEDury gets away with putting out false and misleading information?

For one thing it makes all other information suspect as well.

Just what we need when investors aren't investing because of uncertainty.

But ... Joe, the plumber, the intended consumer of this horse manure, well ... he puts away his pitch fork so that the status quo is maintained.

Apr 26 11:05 AM

[William Cowie:]

Yet another manifestation in the government's "trust us" plan. "We won't tell you what we're doing, because if we were to tell you, you'd panic and everything would be lost. We obviously can't have that, so you have to understand why we can't disclose anything. In the meantime, we'll throw you a bone or two to show you we're not sitting on our hands, we're working HARD to solve this problem."

Apr 26 11:06 AM

[henarl:]

The government does not want a more stressful test that might prove some very large banks to be terminally insolvent. There have already been many small and medium banks fail and the FDIC could not stand to have a big one go down. This "stress test" is nothing more than a govt. PR scheme to pacify an angry population and prevent bank runs.

Apr 26 01:40 PM

[Rumpole:]

"...the only alternative is for the government and banks to somehow "muddle through". This is the real purpose behind the Stress Tests, PPIP and the changes in the FASB rules and the hope is that with enough distractions and obfuscation the problem will heal itself."
Never a truer word written!
Tell me something, if instead of pumping trillions into the banks directly, if the government would have put it into the hands of home owners who were in trouble, wouldn't it have largely solved the problem from the outset? After all, the home owners would have used it to keep paying their mortgages and staying in their homes, the smaller banks and mortgage companies would still have money coming in and the mortgages they securitized would have kept their value better and the larger banks wouldn't have faced the crunch brought on by plummeting mortgage securities values?
Would have this approach been so bad in light of the current situation?

Apr 26 01:53 PM