In its report issued today regarding the Supervisory Capital Assessment Program (SCAP),” the Federal Reserve admits that the economy has deteriorated since it announced the program in late February.1
However, there is no recognition of the primary failing of SCAP — that its stress tests are based on premises that are blatantly milder than those traditionally used by regulators and credit rating agencies.
The fundamental question underlying traditional stress tests for financial institutions is, or should be:
Assuming debt default rates, market declines and other financial or economic conditions similar to those of the Great Depression, would each institution have adequate capital to cover its expected losses?
For example,
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When Congress mandated a stress test for government-sponsored enterprises (GSEs) in 1995, it assumed a 10-year recession, e.g., an economic scenario equivalent to the Great Depression.2 In contrast, the assumption underlying SCAP is a two-year economic decline.
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When Moody’s and Standard & Poor’s sought to determine the capital needs of Ambac, MBIA, FGIC and other financial guaranty insurers, their stress tests assumed peak municipal bond default rates of the 1930s, as documented in a PhD dissertation on the experience of the Great Depression.3 In contrast, today’s Fed report on SCAP makes no reference whatsoever to a depression.
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In November of 2008, The New York State Insurance Department issued a circular to all New York authorized insurers stating: “Insurers should systematically review their stress testing and scenario analyses, especially in light of recent market events. In a robust process, inputs, assumptions, stress scenarios and the resulting impact must be continuously monitored, assessed and updated. Scenarios may include interest rate shocks; equity market shocks; yield curve shifts; changes in credit quality and liquidity; rating agency downgrades; collateral calls; and large-scale catastrophes.” Although the department does not specify macro-economic scenarios, their stress testing is likely to be significantly tougher than SCAP’s.
By applying worst-case scenario stress-testing, regulators seek to (a) flush out true deficiencies among financial institutions that need urgent rehabilitation (b) help build confidence in the remaining institutions, and (c) ultimately strengthen the financial system as whole.
Indeed, in her March 9 presentation to the Brookings Institution, “Lessons from the Great Depression for Economic Recovery in 2009,” CEA Chairwoman Christina D. Romer explained it this way: “When Roosevelt took office, his immediate actions were largely focused on stabilizing a collapsing financial system. He declared a national Bank Holiday two days after his inauguration, effectively shutting every bank in the country for a week while the books were checked. This 1930s version of a ’stress test’ led to the permanent closure of more than 10% of the nation’s banks, but improved confidence in the ones that remained.”4
In contrast, stress tests perceived to be milder than true worst-case scenarios can have the opposite impact on public confidence, leaving the tougher questions to the realm of rumor, uninformed financial decisions and, ultimately, public panic. That, unfortunately, is the urgent concern regarding SCAP. Specifically,
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The “more adverse” unemployment scenario assumed by SCAP in its stress tests for the nation’s largest banks is 8.9 percent in 2009 and 10.3 percent in 2010.5 However, the actual worst-case unemployment scenario is the depression-era peak level of 25 percent.
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The more adverse GDP scenario assumed by SCAP is a decline of only 3.3 percent in 2009 and 0.5 percent in 2010. The actual worst-case GDP scenario is the three-year decline of 8.6 percent in 1930, 6.4 percent in 1931, and 13 percent in 1932.
Current Status of Nation’s Largest Banks
For the reasons we cited in our white paper, “Dangerous Unintended Consequences” and our recent press conference, six of the nation’s largest banks are currently at risk of failure, including JPMorgan Chase, Goldman Sachs, Citibank, Wells Fargo, Sun Trust Bank, HSBC Bank USA. This is their current status even without assuming a worst-case future scenario.
At the same time, there are strong banks in the U.S. that could play a constructive role in a future recovery provided that precious capital, whether private or public, is not diverted to poorly managed, endangered institutions.
Conclusion: Unless the stress tests openly recognize the true nature of the challenges faced by U.S. banks, they will merely perpetuate their problems. Rather than bolstering confidence, they risk shattering trust.
Recommendations
Regulators must promptly
1. Redesign the stress tests of the nation’s banks in a manner that conforms to the traditional stress testing of financial institutions, assuming true worst-case scenarios, such as those reflecting depression-era conditions.
2. Retest the banks and fully disclose the results to the public.
3. Expand the stress testing to include other financial institutions, such as investment banks, mortgage lenders, insurance companies, GSEs, and the borrowing capacity of U.S. Treasury itself.
4. Undertake similar stress testing for essential infrastructural and mission critical functions of local, state and federal governments.
1 http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090424a1.pdf, pdf page 8.
2 “More Questions Than Answers; GSE Stress Test,” National Mortgage News, February 13, 1995
3 Hampel documented 3,252 municipal bonds in default at the peak of the Depression in 1935. George Hempel, The Postwar Quality of Municipal Bonds, unpublished PhD dissertation.
4 http://www.brookings.edu/~/media/Files/events/2009/0309_lessons/0309_lessons_romer.pdf
5 http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090225a1.pdf
{ 16 comments… read them below or add one }
Dear Martin,
They say if too many investors know about any trend, then the trend changes ( or is rather changed by market movers) abruptly and suddenly , to catch investors unaware.
Now that your recent Book is getting really popular and more people are reading it, how do you think Wall Street fat cats will play out the markets?
Govindarajan
Why SCAP should be SCRAP
Dr. Weiss:
Thanks for all you do to help us less educated folks gain some measure of understanding of the current problems facing our nation.
I have ordered from Amazon your current depression book and another on investing without fear. When they arrive I will read them with a great hope my ability to understand will be enhanced, and I will be better able to preserve and protect what assets we still have left due to this melt down caused by the poor judgement and oversight of our political leaders.
I’ll be 80 in November. I hope to have enough dollars to take care of my wife who is younger than I, and maybe leave a few bucks to our children and grandchildren. After all is said and done, this entire challenge is to teach each of us how we can better take care of our families, our personal responsibilities – and making our nation stronger.
Again, thanks for all you do!
Sincerely,
ARJ, Jr.
Dear Martin: We as taxpayers seem to “get it” so why is it so difficult for Congress to not see it? Could it be denial, plain and simple? Are they that afraid of losing their jobs that they do just as Ken Lewis did, hide the truth to keep his job?
Shame on all of them.
If you feel your 30,000 names will have any influence, you will find that it was a waste of our time. The 40 million free loaders now on the public dole and paying no income tax at all far outnumber us and will vote for anything this administration says will keep the gravy train rolling to their mailboxes.
Sad but certainly true, Socialism is here to stay.
From what I have read, these stress tests are designed to make the large banks (investment companies) look good and the smaller, stronger regional banks look worse than they are. It strikes me as more than a coincidence, that I saw a headline not that long ago stating Morgan Stanley was looking to buy up smaller regional banks.
TOKYO (MarketWatch) — Morgan Stanley is considering the acquisition of U.S. regional banks in a move to boost the company’s retail banking operations, according to an article in the Nikkei newspaper Tuesday. (April 20, 2009)
At this point, I don’t know who is calling the shots in Washington…The banks or the government. Actually I think they are in bed together and laughing all the way to the bank. A few people are getting extraordinarily rich from this and a whole lot have lost everything they have ever worked for.
Unless the voters who GIVE outnumber THE TAKERS we will have the un-representive form of government.The GREED of the 535 so called MEMBERS that are supposed to represent ALL the voters ,we as a NATION are going to FAIL!! THROW OUT these elected officals and hope that voters get smart and REQUIRE ACCOUTABILITY from our so called CAPITAL FORM of goverment!! The NEW represenatives will be required to have benifits that are in line with the common VOTER!! A FORMER leader of a social FORM of goverment WARNED us that WHEN the TIME comes we will WELCOME SOCIALISM FROM WITHIN!! If the government controls the BANKS,INSURANCE,PENSIONS and COMPANIES, please inform this writer of the difference, between the conflicting forms. Just who in this world believes that we are better off today than our ancestors!! In closing DON,T forget to FLY the FLAG of FREEDOM. WHAT COLOR IS IT??
Among the many solutions avaiable…The public census is far more usefull when tabulated every five years. A tenable regulated remuneration threshold and ceiling formula must remain provided, and also enforced in order to prevent deliberate financial fraud “from the get go”. Think clearly over in your own mind – everyone – Discern and Report to a competent entity each mal-adroit deception of the public trust, of the private trust, of the personal trust – that you encounter, or simply keep a “coucher book”, a journal observation recordation of such evident findings, and follow through to prosecution of the same. Which if such deception, treason, or and absence of common fealty is not halted, prosecuted and prevented – it shall have to be placed into the hands of a much higher authority. The flagrant notion of tyranny is not specific to any one period of time, nor to any one situation of economic species. But you are able to observe, recognize, identify, and litigate in opposition to such arrogance. Whether the willful and knowing deliberate intent to deceive, or and intimidate, in contempt of this nations’ constitution – or and subsequent articles of law enacted – is discovered as evident maliciious conduct, and is of a citizen, a denizen, or of an individual persona non grata…I thus quote; “In that I may pass this way but once, let me do what good that I may, because all that evil needs to persist is for good men to to nothing”.
Martin,
Thank you for trying to keep us “in the know”; while it becomes more obvious that the government spins more wool, for our eyes!
How is it possible that such “smart” people rubber stamp such ill-thought out bogus schemes?
My new tax bill came- the final outcome of all these shenanagins… an $800.00 INCREASE, for less services! (On a fixed rate mortgage!)
Thank you also for helping those who can not help themselves, Ron
Martin,
I am an employee of the State of North Carolina. Our state has been hard hit with unemployment at over 10%. Today the governor order an emergency paycut of .5% for all state employees the next two months. It might not sound like much but if you are the affected by the paycut it seems like a big deal. The State legislature is proposing a 7.7% pay cut for the next fiscal year which begins July 1st, 2009 according to the State Employee’s Newsletter and the governor is proposing a 1.5 % paycut. That is almost 10% of our pay should these proposals be enacted. This is really going to hurt.
Dear Martin D. Weiss, Ph.D.:
Thank you very much for discussing banks.
http://www.msnbc.msn.com/id/30293344 has
“Small banks angry about treatment of big ones
‘Why are community banks paying for the sins of Wall Street banks?’”
I discuss dealing with the financial crisis and other topics on
http://sites.google.com/site/kenstremsky/Home/global-thinking-expanded
I have links to many articles on it.
Martin:
Please help me understand something in the SCAP. IN your article you state the following:
“The more adverse GDP scenario assumed by SCAP is a decline of only 3.3 percent in 2009 and 0.5 percent in 2010. The actual worst-case GDP scenario is the three-year decline of 8.6 percent in 1930, 6.4 percent in 1931, and 13 percent in 1932.” (Italics Mine)
From Table 1 under the subheading “Real GDP” the numbers given in 2009 are all negative whereas the numbers in 2010 are positive. So, using just the adverse scenario is the SCAP estimating that in 2010 the GDP will grow by (or to) .5 or as you state decline by .5? If the SCAP meant to estimate yet another decline in the GDP for 2010 wouldn’t the numbers be negative (notice the House prices section where they improve but are still negative).
I’m reading this as the SCAP is actually no only estimating an improvement but will be positive in the GDP in 2010. …or did they simply omit the minus sign? …or am I misreading this table?
THERE IS NO DOWNTURN YET.. FED TO PUMP IN WHAT EVER IT TAKES TO SAVE THIS DELIEMA. 2ND HALF OF YEAR COMES COMMERICAL FORCLOUSURES AND THE LINGERING CREDIT CARD DEFAULT..MYSELF I CAN NOT BELIEVE THIS RALLEY WITH HUGE BANKRUPCTY’S…
TODAYS POP ON HOUSING NUMBERS…
THERE ARE TO MANY PEOPLE SHORRING UP THIS MARKET, WE WILL KNOW MORE COME THUSDAY AND FRIDAY OF THE TRUE DIRRECTION. IT’S UP NOW.. AND WILL CONTINUE TO RISE…
MICHAEL FOX
Hello Dr Weiss
After reading your book I got so scared that i have sold all my stocks in different account last week , but after the recent rallies in the stock market , i don’t know what to think any more , it looks like every bad new is good news , and every body talks about S&P 1100.
what about the sign of recovery they are now talking about ?
how fare do you think this market will go up , before it goes back down?
also if its possible i like to read the answer to the questions raised from your other readers ?
YOU KNOW I WATCHED BUSH GIVE OUR MONEY AWAY AND HE COULDN’T GET RID OF IT FAST ENOUGH. HE GAVE TONS OF IT TO MEXICO (HE HAS SEVERAL RELATIVES MARRIED INTO HIS FAMILY FROM MEXICO AND LAURA BUSH ALSO HAS ANCESTRY FROM THAT COUNTRY). AND WHILE SMALL BUSINESSES IN THE U.S. WERE GOING BANKRUPT HE WAS GIVING MILLIONS TO SMALL BUSINESSES DOWN THERE THRU HIS AMBASSADOR TO MEXICO TONY GARZA. WHILE UNIVERSITIES WERE HAVING A HARD TIME UP HERE, GARZA WAS GIVING $5 MILLION I READ TO EACH MEX. UNIVERSITY HE CHOSE. WHEN AMERICANS CRIED OUT FOR A FENCE (WHICH HE NEVER DID WHAT HE SIGNED AND IT WAS ALL A SHAM ON HIS PART BECAUSE HE WANTS TO “MERGE” US WITH MEXICO (& CANADA) AS PART OF HIS FATHER’S ONE WORLD GOV’T DICTATORSHIP PLAN TO MAKE THE NORTH AMERICAN UNION); WHEN AMERICANS CRIED OUT FOR A FENCE, HE WOULD NOT DO IT BUT GAVE EGYPT $13 MILLION AND LATER MORE MILLIONS FOR A FENCE FOR THEIR COUNTRY! THIS HAS ALL BEEN PLANNED FOR A LONG TIME BY THE GLOBALISTS; THEY HAVE TO DESTROY OUR NATION IN ORDER TO MAKE US PART OF THE ONE WORLD GOV’T DICTATORSHIP AND BRING IN A NEW FORM OF MONEY AFTER DESTROYING THE DOLLAR. I HAVE AN IMPORTANT QUESTION THOUGH: WHAT DO YOU THINK OF ANNUITIES (AMERICAN ONES LIKE WESTERN SOUTHERN OR EVEN FOREIGN ONES LIKE ALLIANZ) – DO WE KEEP OR SELL? AND HOW QUICKLY?
My friends and I appreciate very much your efforts to warn and to assist us with financial direction.
We wonder what to do about some Ibonds coming up for renewal.
Thanks.
To quote you,
“We will have a recovery someday. But only AFTER we honestly recognize the grave mistakes of the past and own up to the hard sacrifices still ahead.”
What are the sacrifices to which you are referring and what would you do if you were running the government?
I’m writing a paper for a grad sch economic history course and would love a reply,
not that I expect one :(