No Stress Over Stress Tests

The recent government-enacted “stress tests” of banks reveal some serious flaws. One of the errors was pointed out by the Financial Times, which reported that,

“During the tests, policymakers made adjustments after first-quarter operating revenues were stronger than forecast, reducing demands for equity by nearly $20bn compared with original estimates based on data for the end of 2008.”

This tells us that if year-end 2008 operating results would have been used, the required capital needed to be raised should be approximately $95 Billion. Yet, the mirage of 1Q09 results further highlights the extent the government authorities went to ensure banks recorded a profit. For a detail discussion of the shenanigans that led to the “stellar” reported bank revenues, see my post here. Moreover, the original estimate to use 2008 data is even more questionable because 1) some banks will not continue to benefit from assets which most likely will be sold in the near future (e.g. Citi), 2) it is unlikely that what had become traditional sources of income for banks (e.g. CDO issuance, securitizations) will continue in the future. Regulators could have used another year, say, 2003, when the use of leverage by banks was less. Of course, this was not going to happen because capital needs would have easily risen to triple digits.

Take a closer look at Citi, for example. The Federales estimated earnings (ex-provisions) for this year and next to total $49 billion, which is approximately the yearly average going back to 1999 (excluding 2008). If the government used this average as guidance, it is deficient because it is not a forward-looking estimate. A reasonable earning parameter “stress test” would have been to use, for example, 50% of aforementioned figure.

All considered, what the public has received are cooked books and cooked results, and if one does not take adequate precaution, somebody is going to get cooked. The stock market has not considered any of this. If it had, it would not have climbed higher the day after the “stress test” results were released.