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Don't Get Overly Exuberant About the Stress Test Results

The Brookings Institution's Douglas J. Elliott filed this guest blog post:

The stress test results are in and the news is good: The banks do not need a lot of new capital and the taxpayer will be called on to add very little of what is needed.

Don’t get too happy, though. The results represent a guess by the federal regulators about how the banks would handle a recession somewhat worse than we expect. It’s a highly educated guess, but still a guess about a very uncertain future. There are unprecedented aspects of our situation and no one should feel too comfortable about their forecasts. The real stress test will be comfortably surviving the large amount of pain still to come this year and 2010, as the effects of the severe recession flow through to loan losses.

There is a wide range of uncertainty around the government’s estimate that $75 billion of new common stock is needed. These banks have about $10 trillion in assets. If their value were just 3 percent lower than projected at the end of 2010, it would mean an additional $300 billion of capital would be needed.

Many have criticized the stress tests as a whitewash and asserted that the low level of capital requirements resulting from the tests is an artifact of the political constraints -- specifically the desire to avoid going back to Congress for more money from the government's Troubled Assets Relief Program. I do not give this argument much weight, because the regulators could clearly have gone $100 billion higher without hitting serious political problems. To understand how this can be, despite the fact that we’re down to only $110 billion of unallocated TARP money, it is necessary to understand a bit about the mechanics of the test.

The banks were actually given two results. First, they were told how much total Tier 1 capital they needed, which includes both common and preferred stock. The banks did very well on this basis, needing less than $10 billion of additional capital.

Second, they face a new requirement to have at least two-thirds of the minimum capital in the form of common stock, which is the strongest form of capital. This test is tougher and resulted in the $75 billion figure. However, virtually all of this could be raised by simply converting the government’s preferred shares into common stock, requiring no new TARP money.

So, a considerably larger capital requirement could have been met without exhausting the TARP funds. The fact that the regulators stopped so far short of this limit suggests that this really is their best guess, not a politically manufactured figure.

However, pureness of intent and accuracy of prediction are different things. The regulators are probably right that we can get through without further major capital injections, but there is almost as strong a chance that at least some further capital is needed beyond the $75 billion.

Intelligent pessimists like New York University’s Nouriel Roubini predict losses for the system that are at least $500 billion bigger than assumed by the stress tests. I don’t know who will prove to be right. The point is that there is a very wide range of possible results. We need to be prepared to respond to whatever comes along. If the government’s assumptions prove to be wrong we will need to buckle our seats belts – the ride will be a lot bumpier than the smooth path illustrated in the stress tests.

--Douglas J. Elliott is a fellow in economic studies at the Brookings Institution's Initiative on Business and Public Policy. He was an investment banker for two decades, principally at J.P. Morgan.

By Sara Goo  |  May 8, 2009; 10:26 AM ET
Categories:  Banking  
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Comments

According to the WSJ, the stress test wanted banks to have a 25-1 common equity to Tier 1 assets leverage ratio. A 25-1 tier 1 common equity ratio in some sense understates the risk regulators are signing off on. Tier 1 assets are less than book assets. This means that the Fed thinks it is alright for mega banks 30-1, 35-1, or 40-1 leverage ratio based on book assets.

If one looks at market prices or the stress test results, Goldman Sachs seems to be one of the healthiest of the top TARP recipients. Nevertheless, from my calculations on pages 20 to 21 of “The Goldman Sachs Warrants” at http://ssrn.com/abstract=1400995, Goldman Sachs assets had a 5 percent standard deviation from January 1, 2008 to May 1, 2009. (On May 1, 2009, GS had a 15-1 leverage ratio of book assets over the market value of common equity.)

At more leveraged banks, a 5 percent standard deviation of assets means that there is a substantial likelihood that their assets will be worth less than their liabilities. It is too bad that the Fed also believes judging from its actions with regard to Bear Stearns and AIG that taxpayers should be on the hook if these banks turn out to be insolvent and in need of emergency help.

www.linuswilson.com

Posted by: Linus_Wilson | May 9, 2009 10:57 PM | Report abuse

It seems to me the government is bending over backwards not to find any of these megabanks insolvent so they can safely ignore the law:

US Code Title 12, 1831o, Prompt Corrective Action

William K. Black has got it right: This crisis stems from massive, pervasive and blatant FRAUD, but nobody wants to call it by its name because then they'd have to do something about it -- or at least explain why not. We're being taken for a ride, again. Obama's administration is hardly off the ground and they've already lost me. I don't see any change I can believe in here.


Posted by: farhill | May 10, 2009 12:11 PM | Report abuse

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