Stress Test
Don’t worry, I am not asking you to remember the day, date and location of your first date with your significant other…
Recap:
On March 5th the Dow closed below 6600, the S&P closed at its lowest since Dec 1996 and Citi managed to drop below a dollar. If this news was not depressing enough, an economics professor at Harvard says there is a 20% chance of a depression (and further elaborated that the 1/5 estimation is on the optimistic side.)
Back to the stress test:
The government stress test is expected to be carried out later this month. The goal of the stress test is to see how much capital the banks need to remain solvent and how much money the government will need to invest in order to absorb losses and ensure that the banks are able to sustain lending. Though the final details of the stress test have not been released (or decided), three major scenarios are being looked into during the initial discussions. Will the banks be able to remain solvent if:
i) Unemployment hits a whopping 8.9% in ’09 and 10.3% in 2010.
ii) The Case-Shiller (housing) index declines 22% in ’09 and 7% in 2010.
iii) The GDP contracts 3.3% in ’09 and 0.5% in 2010.
It is important to note that the stress test guidelines are a good indicator of how the government is expecting 2009 and 2010 to pan out. The stress test is set to give banks an idea of what they did right in the past, where they are currently weak and what they should expect in the future (keeping in mind current geo-political stresses and trends).
Now that I have explained what the government is hoping to achieve by using a stress test, I will now show you why this is all a huge waste of time. First, crises don’t occur at the drop of a hat. Unemployment will not instantly hit 10.3% and cause havoc. Most serious problems occur as a series of events. For example, sub-prime loans were only 14% of the US financial market. The problems arose when banks started to package and tank up on AAA rated mortgages as if they were AAA utilities. It is only then that sub-prime became an issue. In short, one ”bad” piece of news will not cause the economy to go down in a tail spin.
Second, can the test be objective? Scenario one: the same test is administered to all banks. The problem with this is that all banks are not the same. For instance Citi Bank and Goldman Sachs are in very different positions. Thus, giving all banks the same test inadequately models the situation and will fail to generate useful information. Scenario two: each bank gets a customized stress test. The problem with this strategy is that there is a chance that the test givers bias (how’s that for a technical term?) may come into play. However, I will be magnanimous for a moment and assume that the test will be extremely fair. In this case, how will the banks be compared on a level playing field if they are been given different tests?
Third, all banks were forced to take TARP 1.0 because the government did not want to single out the banks that needed the money. What is going to happen when a bank fails the stress test and needs more capital? Is it OK for the market to punish the stock now?
Furthermore, there is no guidance on whether the government is going to use tier one capital (common stock, preferred stock and hybrid debt and equity) or tangible equity capital (focus on shareholders equity) to gauge the health of the banks.
How do further capital injections in the absence of altering business models solve anything? AIG just required another $30 billion, after all the money they have already received. Much to GM’s chagrin, their auditors and accountants have said that the company can not function in its current state and will need to file chapter 11 and restructure to remain viable (a fact that GM continues to vehemently deny). Nationalization (or pre-privatization) could be a temporary solution. However, the issue of Moral Hazzard still remains.
