Stress Test for Banks Uses Wrong Assumptions

Posted by Michael A. Kamperman on April 25, 2009

The bank stress test devised by the Treasury is meant to measure potential losses based on two perceived scenarios.  The first scenario is the baseline scenario for the economy in 2009 and 2010, which is an average of the expected outcomes for the economy forecasted by blue chip economists.  The second scenario is a worst case outcome forecasted by the same economists.  The problem is the economy has deteriorated much more quickly than the baseline assumptions used in the stress test.  The expected forecast for the end of 2009 is for unemployment to reach 8.4%, for the economy to decline 2%, and for home prices to fall 14%.  The worst case for the end of 2009 calls for unemployment to reach 8.9%, the economy to decline at 3.3%, and for home prices to fall 22%.  Right now unemployment is 8.5% and will increase to close to 8.9% by the end of April.  With weekly jobless claims still averaging over 600,000 per week the unemployment level can be expected to rise much higher from here in 2009.  Additionally, estimates for first quarter GDP are running at -5%.  The only way for the worst case scenario to be avoided at present is for the economy to actually start to grow and add jobs in the second half of 2009.

So the question is why doesn’t the Treasury go back and redo the stress test?  My thoughts are the stress test is not really meant to see how much more the government needs to do to shore up the banks.  The goal of the stress test appears to be a way to restore confidence in the banking system in the eyes of the public and in the eyes of Wall Street.  The Treasury hopes the vast majority of banks will be able to raise large amounts of private capital to cushion further losses in front of further potential government assistance.  This has all the shades of FDR’s scheme to close the banks and declare only healthy banks were allowed to reopen.  But this is not 1933.  We live in an age of instant global communication.  Most of FDR’s listeners on the radio didn’t even know he used a wheel chair.

This raises the most troubling question of all.  Is the stress test the best plan Treasury Secretary Geithner could come up with because the political will to do what it takes to solve our economic crisis does not exist in Washington?  I grow increasingly worried day by day that the only logical answer to the above question is the political will to solve the economic crisis is absent in Washington.