THE DAILY BLADE: All Stressed Out
Not having majored in economics, when The Stiletto first heard the term “stress test” being bandied about in the context of financial institutions, she had no idea what that could mean. The only stress testing with which she is familiar is used in cardiology and engineering. So based on this prior knowledge, The Stiletto formed a mental image - now indelible, unfortunately - of Tiny Tim Geithner forcing middle-aged Masters of the Universe to jog on treadmills while holding heavy accounting ledgers, until they beg for mercy and give back their taxpayer-funded bonuses.
So The Stiletto was eager to read Geithner’s op-ed in The New York Times, “How We Tested the Big Banks.” Alas, he never quite got around to “how” as he was too busy explaining the “why” – and, with a heavy dose of spin:
The effect of this capital assessment will be to help replace uncertainty with transparency. It will provide greater clarity about the resources major banks have to absorb future losses. It will also bring more private capital into the financial system, increasing the capacity for future lending; allow investors to differentiate more clearly among banks; and ultimately make it easier for banks to raise enough private capital to repay the money they have already received from the government.
Clearly The Stiletto had to do her own research, and found this helpful Associated Press article:
The “stress test” is actually two tests measuring how much value banks’ assets — loans it’s made along with various other investments — would lose over the next two years under different economic scenarios.
The first scenario was based on predictions about the current recession. It assumed unemployment will reach 8.8 percent in 2010 and house prices will decline by 14 percent this year. The second scenario was for a worse-than-expected downturn. It said unemployment will reach 10.3 percent in 2010 and house prices will drop by 22 percent this year.
After testing banks’ assets to see how much value they could lose, officials compared the losses to the banks’ capital cushions - basically, the money they’ve got in reserve - to see if the banks could survive a bad recession.
Here’s a bit more useful information from SmartMoney:
† The banks were asked to project their credit losses and revenues for this year and next, including the level of reserves that they would need at the end of 2010 to cover expected losses in 2011.
† Projections were made based on two different economic scenarios. A "baseline scenario" that reflects the Fed’s February 2009 economic expectations … [a]nd the “more adverse scenario,” which illustrates a longer and more severe recession …
† Banks had to provide supporting documentation, including information on projected income and expenses. The Fed’s examiners developed “independent benchmarks” based on the portfolio characteristics of each bank to decide whether the bank’s loss estimates were appropriate - and how the bank would absorb those losses.
† Each bank’s projected losses, revenue and changes in reserve were combined to evaluate the amount and quality of capital the bank would have at the end of 2010. If a bank was found to have less capital than projected by the stress test under the adverse scenario, it would have to augment its capital, or create a “capital buffer” that it could use to offset losses if the economy turns out to take an even bigger turn for the worse than expected.
The Stiletto surmises that these various scenarios were played out using the same sorts of computer projections that predict global warming. In other words, garbage in, garbage out. As The Washington Post puts it:
Of course, the most important variable is how the economy will really perform. The stress tests are not an evaluation of the banks' health under current or projected economic scenarios but an attempt to determine what they might need if things get much worse. If the economy is on the mend, and the banks' loan portfolios start to improve, the stress-test scenario will look unduly gloomy. If the economy takes a real dive, hundreds of billions more could be needed.
So after all the hoo-hah, out of 19 financial institutions only one - GMAC, the finance arm of General Motors, was deemed to require an additional taxpayer bailout. Nine others, including Citi, Morgan Stanley and Wells Fargo, were advised that they needed to raise additional capital within six months in private markets.
But things may not be quite what they seem, reports the WaPo:
Some major banks managed to wrest concessions from the government in closed-door negotiations over their "stress tests" that helped them put the best face on their results, financial analysts, industry officials and sources said.
The banks were intent on sending a message that they were strong enough to weather the economic storm and didn't need additional capital infusions from the government that could all but nationalize their franchises.
Citigroup successfully pushed to lower the amount of common equity it needs to raise to $5.5 billion by applying $52.5 billion from capital it has not yet reworked. It also was able to get a credit for the sale of a unit that has not been completed. …
Several banks were displeased with the amount of capital the government concluded they must raise and lodged their complaints with Fed leaders.
When asked in a call with reporters about its seeming success in the negotiations, Citigroup Chief Financial Officer Edward Kelly said the firm still had issues with the tests. He said the principal difference of opinion centered on revenue the bank would generate if the economy worsened. He declined to discuss the specifics, saying talks with regulators were confidential.
"I can't really tell you how they came up with [their] number. I couldn't tell you even if I knew, which I don't," Kelly said to laughter.
All of which leaves The Stiletto as mystified as ever. This all sounds like voodoo economics.
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