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Background on the Stress Tests: Anyone Got an Extra $120 Billion?
Most news outlets seem anxious to join the Treasury's PR campaign in pronouncing the banks essentially healthy based on the stress test results. There is of course enormous uncertainty around the course of the economy over the next few years, and the results of these stress tests may well prove to be an accurate assessment of the banks' health, but there are some reasons for believing that the stress tests are likely to prove too lenient.
1) Fraud in mortgage issuance -- we know that many of the loans issued in this period involved fraud, more often on the lenders' side than the borrowers. In these cases, for example where the mortgage application grossly overstates the buyers income or the appraisal hugely overstates the market price of the house, default rates will be far higher than would be expected even in bad economic times. Also, recovery rates will be far lower if the original appraisal price was inflated.
2) Unemployment -- in their negative scenario, the stress tests assumed a year-round average unemployment rate of 8.9 percent for the 2009 and 10.3 percent for 2010. The economy is on track to have a much higher unemployment rate, as it is likely to hit 9.0 percent in April. My best guess for a year-round average would be 9.4 percent for 2009 and probably around 10.5 percent for 2010. (These numbers assume no second stimulus, but of course Congress will not sit back and just let the unemployment rate go through the roof.)
3) House prices -- the negative scenario assumes that house prices, as measured by the Case-Shiller 10-City index fall 22.0 percent in 2009. Prices in this index have been falling at a 24 percent annual rate in recent months. Given the massive inventory of unsold homes, It is reasonable to expect that this rate of price decline could continue at least through 2009.
What difference would harsher assumptions make? The projected loss rate on first mortgages increases by 45 percent between the baseline scenario and the negative scenarios in the stress tests. The baseline scenario assumes an 8.4 percent unemployment rate for 2009 and 8.8 percent for 2010 (some serious stimulus here), compared to the 8.9 and 10.3 rates in the negative scenario. The rate of house price decline in the baseline scenario was 14 percent in 2009 and 4 percent in 2010, compared to 22 percent and 7 percent in the negative scenario.
So, if my somewhat more negative numbers prove accurate let's assume that it increases losses by about 20 percent. That comes to an additional $120 billion in losses. That would mean that instead of having to raise $75 billion, these banks would have to raise $195 billion. That's a qualitatively different picture.
So, are the stress tests worthless? They did provide a much clearer picture of the position of individual banks than we had previously. It is worth noting that this is a 180 degree shift from the original course pursued by Treasury Secretary Henry Paulson last fall. Paulson tried to conceal the situation of individual banks, putting a cloud over all of them. Treasury also should be credited for disclosing many of the specifics of the stress tests so it is possible to do a quick (or more in depth) analysis of its assumptions and explore the implications of alternative assumptions.
Still, it is hard not to conclude that these stress tests and certainly the PR campaign around them, were intended to paint as positive a picture as possible of the banks' financial condition. If this picture proves to be wrong, then it means that we will have unnecessarily delayed the clean-up of the financial system. It will also be bad political news for the administration (Geithner and Summers will presumably be joining the ranks of the unemployed).
Of course, the big second stimulus package that Congress will pass this summer, will save both the banks and the administration.
--Dean Baker
COMMENTS (9)
Anything other than a positive spin would run the risk of setting off a panic, so why aren't the stress tests just considered one huge exercise in mass-delusion?
Posted by: some guy in a cube | May 8, 2009 8:04 AM
Dean,
I'm glad you have begun to mention the fraudulent activities of the banks. The administration, and even more so the Congress, seems intent on ignoring rather than pursuing and punishing the banks for their fraudulent loans.
Krugman had it right this morning when he pointed out that the administration had failed by negotiating the stress tests with the banks. He is also correct in pointing out that neither the administration nor the Congress seems likely to pursue meaningful regulatory reform. Their plan seems to be to insure generous gross margins for the banks and to enable the banks to continue the activities that brought on the crisis.
I believe that thoughtful people should be worried by the Obama administration's weak position vis-a-vis the banking industry.
Posted by: Ron Alley | May 8, 2009 10:08 AM
That comes to an additional $120 billion in losses. That would mean that instead of having to raise $75 billion, these banks would have to raise $195 billion.
This gets at something i'm grappling with. The 'negative' scenario projects further losses on loans & other assets among these large institutions of what, something north of $600 billion in the next 2 years? Under that scenario the additional capital they'd require would be $75 billion (of which more than $60 billion would be new equity, so the amount of real new capital would be maybe $10-15 billion). Is that right?
So that either means that (a) their capital reserves are already sufficient to cover potential losses of $500 billion-plus ... or (b) the amount of capital they need in order to be protected against a loss is some fraction of the dollar value of that loss. You seem to be saying that the answer is (a), but some of what i've read in other sources makes it sound like the answer is (b).
I think the answer to that determines how big a deal it is if Treasury's negative scenario is too rosy. If conditions end up somewhat worse than that scenario & the right answer is (b), then the published new capital requirements should only be off by a little; but if the answer is (a) then the published figures could be off by a huge amount.
What i really wanted to know from the stress tests is, how bad would conditions need to get for each of the big institutions to get to $0 net assets? That's a better metric of their real solvency than just saying how they'd fare under some arbitrarily selected scenario, whether it's too rosy or too dire. Is it possible to estimate that from the information that's been made public so far?
Posted by: TW | May 8, 2009 10:27 AM
The thing that really concerns me about all of this is that your story is hidden and only understood by a small number of people. The government says, "Everything is fine over her." Everyone cheers and trys to move on with a smile that the worst is over. The great thing for the system is that nothing has changed. All of the things that got us here to begin with are in place and nothing needs to change. In the end when the next wave hits everyone says this could have never been foreseen and we stuff the pockets of the companies with more taxpayer money to prevent, "a collapse of the financial system." The goal here is to actually change nothing and make everyone believe that the government is taking care of things when all the government is doing is focusing on misleading the public and preventing change to a failed structure. Comical if it wasn't so tragic and amazing that this all comes from the administration of the president that ran on change. This all tells me that in fact there will never be any change that is led by the government and it must come from the people or from actual collapse. Neither of which are ideal or enjoyable scenarios. I put my money on collapse since the people have shown that after the 60's they have no taste for bringing about change.
My two cents on the state of the union.
Posted by: John S | May 8, 2009 11:47 AM
Geithner and Summers will presumably be joining the ranks of the unemployed
Oh, I wouldn't worry about Timmy. Something tells me that the former NY Fed chief will make out just fine...
Posted by: patient renter | May 8, 2009 1:22 PM
if there are $120B in further losses and the banks books are otherwise clean, the banks will be able to raise that much new capital very easily. take bank of america for example. in normal times it can probably generate $25B in profits, so it should be worth say $250B. right now the market cap is about $80B. so if they were in a situation where raising, say, $50B would give them a universally recognized clean bill of health, they could do it -- they could raise $50B and this would add $170B to their market cap, so they would certainly do it.
in order for this to work, however, there has to be enough confidence that $50B is all they will need. for that to happen the market needs to be convinced that (1) we are not going into a deflationary depression and (2) the losses on bank of america's books are not massively more than expected and (3) that merrill's trading book doesn't contain some awful surprises. this should be clear one way or another by the end of 2010.
Posted by: qbr | May 8, 2009 9:02 PM
Dean, TW,
The stress tests show, after the TARP $, BOA, Wells & Citi have Tier 1 capital ratios range from 2% to 4%. Many people likely have NO idea what that means. Without elaborating on too much technical details, that's very critical and dire.
Dean forgets to mention these numbers totally support the gov't too-big-to-fail practice.
IndyMac failed last year and you could easily check they had a higher ratio than them and that was b4 TARP $ (I think).
Community banks that were closed likely had higher Tier 1 ratios than the Big 3.
Posted by: James | May 9, 2009 3:31 PM
Anything other than a positive spin would run the risk of setting off a panic
Huh? You mean.... the REAL panic isn't here yet? Uh, oh...
Posted by: Mister Snitch | May 10, 2009 9:12 AM
Good post,thanks a lot.There is not a question of whether there are enough people to possibly be trained to practice medicine. There is only the question of whether you want one more doctor or one more derivatives trader.
Posted by: Links of London | September 8, 2009 2:06 AM