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According to the WSJ, the stress test wanted banks to have a 25-to-1 common equity to tier 1 assets leverage ratio. A 25-to-1 tier 1 common equity ratio, in some sense, understates the risk regulators are signing off on. Tier 1 assets are less than book assets. This means that the Fed thinks it is acceptable for mega banks 30-to-1, 35-to-1, or 40-to-1 leverage ratio based on book assets and book common equity. It is good that regulators are focusing on common equity, but they should require the mega banks to hold more of it.

If one looks at market prices or the stress test results, Goldman Sachs (NYSE:GS) seems to be one of the healthiest of the top TARP recipients. Nevertheless, from my calculations on pages 20 to 21 of "The Goldman Sachs Warrants", Goldman Sachs' assets had a 5 percent standard deviation from January 1, 2008 to May 1, 2009. (On May 1, 2009, GS had a 15-to-1 leverage ratio of book assets over the market value of common equity.) Other mega banks probably had more volatile asset values over that period.

At more leveraged banks, a 5 percent standard deviation of assets means that there is a substantial likelihood that their assets will be worth less than their liabilities plus their preferred stock obligations. It is too bad that the Fed also believes, judging from its actions with regard to Bear Stearns and AIG, that it will make emergency "loans" if these banks turn out to be insolvent and in need of emergency help.

Disclaimer: I only have positions in financial stocks and bonds in long-only, broad-based index funds. This is not investment advice.

Source: 25-to-1 Leverage Earns Banks an 'A' on the Stress Test