The Federal Reserve Board of Governors, in applying their stress tests, announced, "Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized."
The stress test exercise focused on two macroeconomic scenarios. The first was based on publicly available economic assumptions (the "baseline forecast"). The second projection was intended to capture more adverse circumstances in terms of the gross domestic product, unemployment and housing prices.
The primary focus was to determine whether the companies had sufficient cash flow to fund obligations, as well as sufficient shareholders' equity to offset loan losses, under these two scenarios.
The reliance on shareholders' equity as a critical measure of solvency was emphasized in the study. This makes sense, given that the composition of bank capital has shifted from one based on shareholders' equity to one based on debt-like hybrid securities, such as preferred equity and subordinated debt.
However, I am troubled by two major issues. First, the more adverse of the two test scenarios assumes a substantial GDP improvement over the coming year, unemployment reaching a peak at 10.5% and a deceleration in the decline of the housing price index. While these conditions may be more adverse than the baseline forecast, they fall short of measuring stress to the point of failure.
Both tests are based on an improving economy, which may be a reasonable forecast but is hardly suitable to measure performance under duress. It would appear the Fed set out to prove that the companies were stable by avoiding outlier events — such as, shall we say, a global pandemic? — that could stress them to the breaking point.
A more appropriate test would have utilized multiple sets of assumptions, including a worsening economy this year and next year.
The second issue, which should be of great concern but seems to have been minimized in the analysis, is the lack of liquidity within bank capital structures.
A substantial portion of the assets held by the major banking companies are classified as "Level 3," a type commonly referred to as toxic assets. The bankers themselves recognize these assets are hard to value and hard to sell, making them by definition illiquid. They are grouped together on the financial statement and assigned what the company chooses to consider a fair market value. These assets are typically of far lower quality than marketable securities, and they have proven to be even more illiquid during periods of crisis.
To better assess the true valuation of these companies as represented by shareholders' equity, I recalculated the equity assuming a 60% reduction in Level 3 assets would take place under conditions of stress (an optimistic assumption). What I found should raise eyebrows in Washington at a minimum. Even if the fair value assigned by the bankers is remotely realistic, in some cases the adjusted shareholders' equity would actually be negative, and in the majority of cases it would drop below 10%.
For example, if Capital One Financial Corp's Level 3 assets decreased in value by 60%, its shareholder equity would be around negative-$60 billion, or, as an adjusted percentage of total assets, negative-34.3%. Morgan Stanley did not fare as poorly, yet under the same circumstances it would likely face a $40 billion loss in shareholders' equity.
My calculations did not suggest the others would become insolvent, but they would be facing dire prospects, likely requiring a taxpayer bailout or nationalization.
This simple analysis leads me to believe that the Fed has elected to present a far more optimistic picture than the reality the American taxpayer may actually face.
By confining their testing to parameters only slightly worse than the baseline, they have biased the results, in effect mirroring the historic accounting fiction which bankers themselves abused that brought us to this point to begin with.
Based on the results of its study, the Fed has made recommendations to the bank holding companies, including an assessment of the capital needed to ensure "the safety and soundness of individual BHCs and the stability of the broader financial system" through next year. We should be confident that their recommendations are adequate as long as actual events do not prove to be particularly stressful.