Federal Reserve's Stress Test Offers Few Surprises Yet Results Still Dour

Published May 8th, 2009 - 03:59 GMT

After weeks of waiting, an impromptu delay and rumors whose source seemed to be policy officials themselves, the Federal Reserve finally released the results of its highly anticipated Stress Test. Ultimately, the net results were more or less in line with expectations. Ten of the 19 banks under review were judged to have insufficient capital to survive an extended recession and were told that they will need to raise their capital levels to fortify their positions in the market.

The short-falls ranged from massive (Bank of America needs $33.9 billion) to relatively modest (PNC has fallen short $600 million). However, should these ambiguous numbers cull the need for further concern; or are the scenarios the central bank measured these firms against just as much an exercise of speculation as a traders forecast?

The Score

To fully understand the implications of this stress test, we have to first look at the ‘raw data’ that the Fed has passed along. The nineteen banks put up to the Fed’s tests account for approximately two-thirds of the assets and half of the loans in the US banking system. Clearly, systemic risk can be largely encapsulated by this heavily weighted group. From the data, the first concern traders have had was the list of those banks that would fail to meet the capital requirements to ride out the government’s worst case scenario for the economy and those that were well positioned. As expected, 10 of the banks were judged to have insufficient reserves; but this came as little surprise considering the market had fully expected as much. In fact, many of the names that populate the list were discounted ahead of time. The accuracy behind the market’s outlook can be ascribed to ‘rumors’ and ‘comments’ from unnamed Fed officials ‘with knowledge of results.’ This was likely an effort encouraged by policy makers to help temper market sentiment to the results before the official numbers were released – and thereby curb a volatile reaction.

The Numbers

Whereas the breakdown of the pass/fail proved to be very accurate, the actual shortfalls were less so (though they certainly came close enough to suggest leaked numbers were being utilized). In total, the ten banks that fell short of their benchmarks will have to raise a cumulative $74.6 billion. This may seem like a parsley sum given the massive bailouts of AIG, Freddie Mac, Fannie Mae and others; but in reality, these funds are expected to come from the public sector. This is a considerable sum to raise considering the state of the economy (a recession is fully forecasted for the rest of the year). Picking out the neediest of the firms, Bank of America (who acquired Merrill Lynch for better or worse) is expected to increase its reserves $33.9 billion. Treasury Secretary Timothy Geithner and executives have suggested that normal methods for raising capital – like converting preferred shares into common stock – will meet the requirements; but what effect that will have on investor sentiment remains to be seen.

Longer Term

Altogether, it seems that the Fed has provided the market with the perfect solution to a lingering problem. However, this exercise in defining boundaries on recession and the impact this malaise has on the market does not accurately account for sentiment. The forecast for recession that the central bank has benchmarked individual company losses against is an act of speculation itself. Perhaps the contraction economic activity will be better or worse than expected. Even more threatening is the possibility of another financial shock that has an immediate impact on credit and liquidity for these firms and the broader market in general. Even if these numbers prove accurate, these 19 companies can still lose $600 billion through 2010. That is substantial in the best of times and at least a severe dampener given current conditions.


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