What they’re saying about the stress test

On the day the stress test results were released, the market was greeted with positive response which extended until yesterday.  Even days prior, the leaks did not seem to deter investors from buying, but instead made it seem like they are getting ready for some positive and awaiting further rally.  On the week, the KBW bank index rose 30% while the S&P saw it’s biggest gain since the early 80s. Despite the results being dubbed by many as anticlimactic due to the leaks, which pretty much took away people’s main reason to celebrate, Geithner & Co.’s goal of instilling confidence seems to have been achieved. Maybe they can sleep sound… for a few nights.

However, even just a day after the results were released, the skepticism that has been there from day 1 only grew further as more details have been provided.  Maybe the investors were satisfied by the amount of capital they are asked to raise, but Geithner & Co. surely didn’t escape the sharp eyes of economists and other critics.

Here’s what some of them are saying:

Mark Thoma writes:

I’ve given a lot of tests over the years, and I can pretty much make the mean on a test come out how I want through the design of the questions and how I score the answers. If I want a mean of 70, or around there, I can get it, and if a mean of 50 is the target, that’s possible too… But a mean of 50 will lead to much more complaining, lower evaluations, and general dissatisfaction with the course than a mean of 70 even if you grade on a curve so that the grades are identical. So, since I learn the same thing either way in terms of relative understanding of the material, targeting a mean of 70 works out better.

But you have to be careful since there is also an absolute standard to worry about. Someone who gets the mean score and a grade of, say, C, is being stamped with a particular level of competence, and the questions cannot be so easy that a C is awarded to students who do not have this minimal level of understanding.

Enrich, Fitzpatrick and Eckblad for the Wall Street Journal:

The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation’s biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.

In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.

Bank of America’s final gap was $33.9 billion, down from an earlier estimate of more than $50 billion, according to a person familiar with the negotiations.

At Fifth Third Bancorp, the Fed was preparing to tell the Cincinnati-based bank to find $2.6 billion in capital, but the final tally dropped to $1.1 billion. Fifth Third said the decline stemmed in part from regulators giving it credit for selling a part of a business line.

Citigroup’s capital shortfall was initially pegged at roughly $35 billion, according to people familiar with the matter. The ultimate number was $5.5 billion.

A little controversial for this blog post at The Market Ticker called the test a “sham”:

According to The Fed’s “More Adverse” scenario prime delinquencies will reach 3-4%.

What’s worse is that a lot of the paper Fannie holds was written before the bubble.  If you look at only the “bubble-era” paper (e.g. ALT-A) or even prime paper written in 05, 06 and 07 the numbers are going to be far worse.

We have the largest lender in the United States reporting current “prime” serious delinquencies, almost all of which will end up as foreclosures, equal to the most serious stress tested level right now and twice the so-called “baseline” scenario.

Last week’s Barron’s noted that commercial real estate is the next shoe to drop and a piece on the WSJ by Peter Eavis was in agreement:

The government’s 13.8% worst-case loss-rate for second-lien mortgages seems fair. But it is a stretch to think Wells Fargo, with its large home-equity book focused on stressed housing markets, will have a lower-than-sector loss rate of 13.2%.

The government may have been too optimistic in positing an 8.5% commercial-real-estate loss rate. This sector is just starting to fall apart, and defaults may move sharply higher as borrowers struggle to refinance loans.

The blogger at Calculated Risk also showed skepticism with the numbers/loss estimates.

Some of the numbers don’t make much sense. Using BofA as an example, the indicative two year loss rates for first lien mortgages are 7% to 8.5%, and I believe BofA is in worse shape (because of their acquisition of Countrywide) than most banks. So I would expect losses substantially higher than the indicative rates. Instead they were lower (only 6.8% of first lien mortgages).

How can BofA only have 9.1% in CRE losses over two years under the “more adverse” scenario? I’d like to see their exposure to C&D, and other categories.

For many of these views, the credibility and usefulness of the stress test is no longer simply being trumped by the inadequate assumption used for unemployment under the “more adverse” scenario (it is already expected to be surpassed by the end of this year vs. the test’s assumption of 2010).  The bigger issue now is the inadequacy of loss estimates for the real estate/mortgages, whose troubles many say to be just beginning.  Geithner & Co may be relieved for now with the warm embrace of the market but it could go completely awry for them, another round of stress for the gang, once the unemployment rate they predicted under the more adverse scenario is surpassed and the commercial real estate shoe does drop. And these are not completely impossible, perhaps coming to us soon.

It should also not be forgotten that the negotiations the banks had with the WSJ highly likely understated the capital that is really going to keep the banks safe from when things go bad.  That probably bought the banks more time – either from being controlled by the government or suffering from further loss in confidence by the market (right now it seems like they have the backing of many investors just by looking at the indexes and the individual performances).  I doubt it bought them the safety pass, that would allow them to escape any likely deterioration of the market.


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