Bank Stress Tests Now Officially a Garbage In, Garbage Out Exercise

Original Link: http://www.nakedcapitalism.com/2009/04/bank-stress-tests-now-officially.html

We've had plenty of company in voicing doubts about the Treasury's so-called stress tests of the 19 biggest banks. To quickly recap the main issues:

The bank will run the tests themselves, using the same risk models that caused the mess. With only ten examiners on average per bank, and most of the banks having very diverse businesses (mortgages, complex structured credits, credit cards, consumer loans, commercial real estate, large corporate loans, small business lending, foreign operations, credit default swaps, other derivatives exposures, foreign lending and FX exposures), their ability to probe the results, from a skill and manpower basis, is dubious, particularly in the capital markets exposures

For the simpler products, there will be no verification of the loans versus the underlying files.

The so called "adverse" scenario, at the time the tests were announced, was far more optimistic than the typical trajectory of a financial crisis. As the IMF noted in its newly released economic outlook, the current mess is likely to prove worse, due to it being an international, synchronized credit crisis (past outbreaks have been at worst regional).

As the economy has only deteriorated since the tests were announced, even more optimistic mainstream economists are coming to the view that the supposed downside case is likely to approximate the middle of the road case, meaning the "stress" in the tests is insufficient.

The Administration has acknowledged this problem with one of its typically Orwellian responses, by saying it will interpret the results more harshly. But how can anyone do that in a realistic way given the inadequate knowledge of the operations, resulting from sending in only enough examiners to have pleasant conversations over tea about the numbers as they came out? Without digging into operational level data and seeing how it is adjusted to produce bank wide results, any understanding is woefully superficial. Even among the big banks, you can't apply the same sort of adjustment to a largely retail bank like Wells versus a bank with incredible product and geographic diversity like Citi. or ones with very substantial trading operations and complex derivatives exposures (JP Morgan, Goldman, Morgan Stanley, as well as Ciit). Pray tell, how do they decide what adjustment to make to banks with very distinct business profiles? And even for ones with largely similar profiles (Goldman and Morgan Stanley), there are very important differences between.

Answer: they haven't done the spadework to make these subjective adjustments. So the whole exercise, which was dubious from the start, is now patently a PR stunt, with the Treasury also having indicated that it wants to have the exercise be seen as having teeth. That means the Treasury has decided on a forced curve, that on their relative ranking, the somones on the bottom will need to raise more equity (either from the public or failing that, the TARP).

The one thing that may change (we stress may, to paraphrase T.S. Eliot, this Administration cannot take very much reality), is that the line on the relative ranking of who is deemed to need more equity or not may be pushed higher. That's the noise being made to reassure the great unwashed public. But whether there is any real difference in outcome is unknowable. All that is certain is a show will be made as to how the process was toughened up.

A relative ranking is a "price of everything, value of nothing" process, definitive yet singularly unhelpful. An absolute measure, of who needs dough and who doesn't, is vital. In fact, we have said repeatedly that that should have been the Treasury's and SEC's top priority after Bear failed. But the procedures were never in place to do that adequately.

From the Financial Times:

Rising unemployment is prompting US authorities to consider taking a tougher stance in judging the results of bank stress tests...

When the stress tests were revealed two months ago, the authorities defined the adverse scenario as one in which unemployment rose gradually to peak at 10.4 per cent in late 2010.

But, since the announcement was made, unemployment has risen much more quickly than was expected, even under the “adverse scenario”...

The authorities believe it is too late to revisit the assumptions underpinning the stress tests. However, it is not too late for them to decide to interpret the implications for capital more stringently. The Treasury declined to comment.

Making such an adjustment would help arguments against claims by critics such as Nouriel Roubini, chairman of RGE Monitor, who wrote on his blog: “The stress test results are meaningless as actual data are already running worse than the worst case scenario.”

The authorities have not yet made a final decision on changing the way the tests will be interpreted. Even if officials do lean in this direction, it may never be visible because they did not specify in advance any precise formula relating stress test outcomes to required bank capital. Moreover, signs of economic recovery could persuade policymakers to disregard the rapid recent rise in unemployment on the grounds that it might revert to the less alarming trajectory they originally expected.

Policymakers also believe that other assumptions in the test still reflect a worse-than-expected outcome.