The implications of the latest 'stress test' for US banks

This may seem boring and uninteresting, but bear with me, read the information provided, and then see my commentary below. This is very important stuff.

According to a press release today from the Federal Reserve:

The Federal Reserve on Monday released a paper describing the methodology used in the stress test in the 2012 Comprehensive Capital Analysis and Review (CCAR) as well as the templates for disclosure of the summary results, which will be issued at 4:30 p.m. EDT on Thursday, March 15.

The CCAR is a rigorous exercise to evaluate the capital planning processes and capital adequacy of the largest bank holding companies. This exercise includes a supervisory stress test to evaluate whether firms would have sufficient capital in times of severe economic and financial stress to continue to lend to households and businesses. The Federal Reserve estimated revenue and losses under the stress scenario based on detailed data provided by the firms and verified by supervisors. The CCAR draws on the expertise of hundreds of staff throughout the Federal Reserve System, including supervisors, economists, markets analysts, and others.

The supervisory stress scenario for CCAR 2012, which was designed in November 2011, depicts a severe recession in the United States, including a peak unemployment rate of 13 percent, a 50 percent drop in equity prices, and a 21 percent decline in housing prices. The supervisory stress scenario is not the Federal Reserve's forecast for the economy, but was designed to represent an outcome that, while unlikely, may occur if the U.S economy were to experience a deep recession at the same time that economic activity in other major economies contracted significantly.

There's more at the link. (Of course, the 'unemployment rate' referred to in the press release is the official rate. Unofficially, removing all the 'politically correct' adjustments to the data, the actual unemployment rate is probably over 20% already, as we highlighted a couple of months ago. A 13% 'official' rate of unemployment would probably translate to an actual rate of more than 30%!)

The 2012 CCAR is a follow-on to the Supervisory Capital Assessment Program of 2009, involving the same 19 financial institutions. When it was announced last year, 24/7 Wall Street called CCAR "too little, too late".

The Fed’s decision is founded on fear that the EU financial trouble could spread and that the U.S. economy could go into another deep recession. Given the level of trouble the Fed has decided to test for, it is odd that it does not conduct the tests more often.

. . .

Part of the macroeconomic “scenario” is that unemployment could reach 13% by early 2013. That is higher than it has been in any recession since the Great Depression. That makes the anticipated conditions very unlikely, but the Fed does not want to appear too soft, particularly if the financial world falls apart. And, it may. Increasingly, analysts say U.S. banks have more exposure to Europe than they admit. Those same banks have made few decisions to weather a storm similar to that of the credit crisis in 2008.

The stock market has become as worried about America’s largest banks as the Fed is. Bank of America and Morgan Stanley trade at levels last hit in March 2009, the depth of the stock market sell-off. The trading is anticipatory, and it may be based on correct evaluations of the problem, which shows signs of getting much worse, as it did three years ago.

Again, more at the link.

Let's be honest: the Fed is doing its best (albeit belatedly). It should have done far more, far earlier: but given the political and economic policymakers at the helm over the past decade or more, that was never going to happen. When the crisis hit, it did its best to shore up the major US financial institutions, and since then has been trying to get them in better shape to withstand a similar (or even worse) financial collapse in the future. Its press release today noted:

Strong capital levels are critical to ensuring that banking organizations have the ability to lend and to continue to meet their financial obligations, even in times of economic difficulty. U.S. firms have built up their capital levels under the Federal Reserve's leadership since government stress tests were conducted in early 2009. The 19 bank holding companies that participated in those tests and in the 2011 and 2012 CCAR have increased their tier 1 common capital levels to $759 billion in the fourth quarter of 2011 from $420 billion in the first quarter of 2009. The tier 1 common ratio for these firms, which compares high-quality capital to risk-weighted assets, has increased to a weighted average of 10.4 percent from 5.4 percent.

That's a significantly better situation than prevailed in 2008 . . . but will it be good enough if the potential Eurozone economic train wreck becomes real, and the world's major economies all derail en masse?

I've been warning about economic turmoil for a long time now, as have many other (and far more knowledgeable) commentators. I know there are many who regard us as Cassandras, 'prophets of doom' who are far too negative and pessimistic. I'd like to say to such people: if the Federal Reserve itself is stress-testing the largest US financial institutions according to the criteria mentioned above, who's being negative and pessimistic now? Clearly, the danger that such an economic environment may come to pass is more than merely theoretical in the Fed's eyes.

I'll be watching for the results of the stress tests on Thursday. I think they may make interesting reading. Remember, too, that no matter how weak US financial institutions may appear, those in Europe are generally in even worse shape. It sounds odd to say it, but for all our problems, we may be grateful we're not in Europe before too long!

Peter