The “Stress Test” Scam

The “Stress Test” Scam
By Mr. Walker


The results are in and, completely and utterly to no surprise at all, the US banking system is in decent fundamental shape. Yup, Dr. Geithner and Nurse Bernanke had the 19 largest banks in the US drop trow, grabbed their balls, told them to turn their heads and cough, and pronounced them in more or less good health. $74 billion short of rude, independent vigor perhaps, but short nothing more than a run of penicillin here and a couple of aspirin there. As needed. Of course it was only last September, when Lehman was allowed to fail for the unforgivable sin of not being Goldman Sachs, that US banking was well and truly on the brink of collapse, with the electronic/institutional equivalent of a run on the system. Since then we have heard nothing but a relentless stream of bad news about the US and world economy. But, carry on folks, nothing to see here. All is well.

The news was not all good, of course. Bank of America needs to raise something like $35 billion in capital to weather a “bad” recession (more on what makes a recession “bad” anon). Citi, the biggest basket case of them all, needs a third injection of capital from somewhere, to the tune of at least $10 billion, and Citi is looking to sell pretty much anything down to the Sharpies, toner cartridges, and paper clips. Other smaller banks need smaller injections of money and after that we’re told should be all set to ride out the storm.

What all this tells us is not anything terrifically important or insightful about the banks. They’re fucked, for years at least, but the fix was pretty much in. Treasury has about $110 billion in TARP money left in the kitty, and Congress has made it crystal clear that having voted for every law that got us in this mess, and having taken money from any WaMU lobbyist who happened to turn up, they are now shocked, SHOCKED that all of this happened. For the foreseeable future Congress is going to stand on the sideline with arms frumpily crossed and do the only thing they do well–hold vacuous hearings and try to make someone else take the blame. So Treasury isn’t getting any more money once that $110 billion runs out. Thus the stress tests would show a result that can be plugged by the available funds and nothing more. After that money is depleted, Colonel Ben and Sergeant Tim will have no arrows left in the quiver save repaid TARP money, the fed balance sheet, and the printing press. Tim and Ben knew that going into the stress tests, so it’s not surprising that the results show a $74 billion hole that can be filled comfortably with a combination of private and public investment.

What is a stress test? When one hears the word “stress test” it conjures notions of something quite kinetic and active. When a design for an airplane wing is stress tested a prototype is built and then put into a wind tunnel where it is subjected to amounts of force it will likely never see in practice. No such rigor or violence was visited upon the 19 banks in question here. The “stress test” was fundamentally an exercise in accounting, and generous accounting at that. Fire up the copy of Microsoft Excel, run a bunch of numbers assuming a pair of economic scenarios as inputs, then try to guess what reserves a bank will need to weather each scenario. As an accounting exercise there is something crushingly boring about most of this, certainly it’s nowhere near as fun as blowing up an airplane in a wind tunnel.

For the stress tests the degree of “stress” applied to the banks was calibrated by two possible economic scenarios for 2009 and 2010. The “baseline” scenario estimates US GDP contracting -2% in 2009 and rebounding to 2.1% growth in 2010. This scenario has unemployment at 8.4% in ‘09, and 8.8% in ‘10, with housing prices down -14% and -4% in those two years. The “adverse” scenario assumes -3.3% and +0.5% GDP, 8.9% and 10.3% unemployment, and -22% and -7% in hosing prices in 2009 and 2010.

Keeping in mind that the data out of a model is only as good as the assumptions the model takes as inputs, the parameters for “baseline” sound rather a lot more like “extremely optimistic” than anything else. For example, GDP contracted at a -6.2% annualized rate in the last quarter of 2008, while preliminary estimates for the first quarter of 2009 suggest an annualized contraction of -6.1%. That’s a scant .1% improvement. Still, the ‘baseline’ scenario in the stress tests assumes we can get back to -2% for the year. With the economy currently contracting at a rate of -6% and change over two quarters, returning to -2% will take some real doing.

On the housing front, according to the Case-Schiller Index (the best we have), housing prices dropped 18.2% during calendar 2008, and that data can be paired with the fact that roughly 19 million homes were empty at the end of 2008, easily a record number. Additionally, people who want to get mortgages today, as opposed to in 2006, have to have exotic things called ‘jobs’ and the US has been shaving half a million of those off the economy every month for some time now.

All of this makes the assumptions of the stress tests look questionable, at least. But let’s look beyond the GDP and housing numbers a bit.

A far more interesting measure of where we are in the business cycle comes from one of the Fed’s own economic measurements. This Fed statistic measures industrial capacity and industrial utilization for the US. Not all statistics are created equal, many can be cooked and spun with surprising ease. However, a few measures cut to the chase like industrial output and capacity.

Total industrial production is everything the home of the brave is making. Consumer goods, business goods, raw materials like oil and natural gas, and power created by utilities. Take a look at this chart:


On the top chart industrial capacity appears to have flattened, meaning very few new factories are being built, wells are being drilled, or power plants fired. On that same chart production itself, as opposed to capacity, is declining instead of flatlining. That is, what we COULD be making has been flat since mid-2007, but what we ARE making is declining rapidly, taking a nose dive since late 2007. Even scarier is the lower chart, which instead of showing absolute numbers shows relative ones. Of our total industrial capacity, what percentage of it is in use and what percentage of it is idle? How many of our factories, coal mines, and power plants are in use, and how many are sitting still? As you can see, that relative number is the worst it has been since data collection started in 1967, and it’s trending rather brutally down. Kind of like a missile in descent. Also, those little gray vertical bars on the charts are previous recessions, and you can decide for yourself how closely recessions track this data for industrial production and capacity. Looks pretty close to me.

Keep in mind, these numbers have absolutely zero to do with banking and Wall Street, save the extent to which credit conditions are impacting purchases by both businesses and individuals. These numbers are about the “real economy.” This is not a robber baron index, it’s a working class index. How much stuff are we making, how much could we make, and what amount of our industrial capacity is sitting idle and what amount is being used. The numbers are uniformly, and somewhat shockingly grim. Which makes me wonder why we don’t hear much about them on CNBC.

Now then, I’m not a merchant of doom, but I try to be a dispenser of realism. Looking at those charts, and recent GDP numbers, it’s hard to call the “baseline” scenario of the stress tests “baseline.” They look more like “highly optimistic” or if you want to get all intellectual and shit, “Panglossian.” The “adverse” scenario then, -3.3% in 2009 and then close to flat in 2010, would move to the “hopeful but not trying to kid ourselves” category. From the very start, it would seem the “stress tests” are using exceedingly gentle amounts of stress. And there are far more stressful situations that are not difficult to imagine.

What is scary is that even using the “adverse scenario” which, upon further review, looks not all that adverse, Bank of America needs another $35 billion to stay afloat. Not to prosper, just to stay in business. If that’s the case, then why would $74 billion of private capital arrive to plug this hole? I don’t know about you, but if I had $74 billion burning a hole in my pocket the first place I would invest it would NOT be the least solvent banks in the home of the brave. Not by a long shot.

But they will be cobbled together, these banks, no matter what the cost to the taxpayer. They are “too big to fail,” so they will not fail, no matter the cost.

There are a few interesting things to watch as we handicap the next few moves. How much private capital can be conjured to help the banks? Again, if it’s my private capital that would be not one solitary nickel, but will others fill the breach? Assuming private capital can’t or won’t make things right, how much taxpayer money will have to substitute for private investment? And, worst of all, what happens if the “adverse” scenario winds up being something rather more optimistic than adverse?

Anybody who says they know the answers to these questions is full of shit. Nobody knows. Personally I hope for the best, but try to confront reality.