What If The "Stress Test" Results Are Completely Wrong

The bank “stress tests” and their results have put the infallibility of the government on the line. If its judgment about the solvency of the large American banks is accurate, then the new capital put into the institutions should carry them until the economy, employment, housing, and access to credit improve. Banks may end up with the government owning more of their common shares, but those stakes will eventually be sold back into the capital markets so that taxpayers can get a return on their money. If bank stocks rise and stay up for a period of a year or two, that is actually a possibility.

The government has a habit of making mistakes when it gets involved in the private sector, either through regulation or ownership. Not every program to improve the economy or employment works. If the government was successful at running private businesses, then the history of nationalization in other countries around the world would be largely unblemished. The decades-long experiments of government control of the economy in the Soviet Union and Eastern Europe would have been a significant enough achievement to have held the centralized economic management system in the region together for decades to come. It did not work out that way and capitalism is the dominant economic force in most of those countries.

Critics of the “stress tests” have accused the government of using the process to get a larger stake in banks. Institutions that fail to withstand the rigors of the process may need to turn to the Treasury for additional capital. Current common shareholders will be diluted, effectively losing control of the governance of the firms. It is a back door form of nationalization.

As it turns out, most of the banks appear to be in a position to come up to the government standards without handing over control to bureaucrats. If so, the testing process will be regarded as perfect. The banks will have strong enough balance sheets to weather any economic storm ahead.

The government’s evaluation of the future of the economy may be off by a startling magnitude, and, if so, the money which will be added to bank balance sheets over the next several months may be entirely inadequate.

The IMF and a number of highly regarded private analysts forecasts losses at major banks around the world at a level much higher than the US government has supposed. Their more pessimistic predictions are based on the economy getting much worse than it is now and staying worse for a number of quarters. The IMF also expects derivatives write-off to rise by hundreds of billion of dollars over the next two years. The”stress tests” do not take that level of catastrophe into account.

One government benchmark for evaluating the banks is unemployment reaching 10%. Another assumes that real estate prices fall 20%. The trouble with those standards is that joblessness may be at 10% by mid-summer and could stay at that level for several quarters which has not happened since WWII.

A failure of “stress tests’ to get the worst case right may mean that American banks will have to raise tens if not hundreds of billion of dollars more than they will under the government’s current forecasts. Taxpayers will have obligations for much more than they can imagine. The “nationalization” of banks will not have been a remote possibility. It will become necessary to keep the system from breaking down as it nearly did at the end of last year.

Douglas A. McIntyre