This weeks article is of course about the topic of the week, the result of the stress test. You can grab a copy of the summary results here.

Since this is a big topic I’ve posted two articles since I couldn’t choose one over the other:

The first article is Banks Won Concessions on Tests by David Enrich, Dan Fitzpatrick and Mashall in the Wall Street Journal. Following is a small excerpt:

The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation’s biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.

In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.

The overall reaction to the stress tests, announced Thursday, has been generally positive. But the haggling between the government and the banks shows the sometimes-tense nature of the negotiations that occurred before the final results were made public.

Government officials defended their handling of the stress tests, saying they were responsive to industry feedback while maintaining the tests’ rigor.

…

The second article is The Scam Of The “Stress Test” by Karl Denninger. Following is a small excerpt:

So now the “results” are out. If you believe any of it.

A banking organization holds capital to guard against uncertainty. Capital reassures an institution’s depositors, creditors and counterparties‐‐and the institution itself‐‐that an event such as an unexpected surge in losses or an unanticipated deterioration in earnings will not impair its ability to engage in lending to creditworthy borrowers and protect the savings of its depositors.

Well there’s our first problem, right in the first paragraph.

A sound fractional lending institution (that is, any banking organization) holds capital against any unsecured loan in the total amount of that unsecured debt so that if and when the borrower does not pay, it has something with which to replace the capital that it loaned out without security.

One instantaneous piece of bad news lept off the paper:

In combination with the losses already recognized by these firms since mid‐2007, largely from chargeoffs and write‐downs on the values of securities, the SCAP results suggest financial crisis‐related losses at these firms, if the economy were to follow the more adverse scenario, could total nearly $950 billion by the end of 2010.

By this definition we already know the “test” is a joke.

My best estimate for residential mortgage losses only is between $2.5 and $3 trillion. The IMF recently almost doubled their loss estimate from $2.4 to 4.1 trillion, Roubini has published numbers north of $2 trillion, and so have a number of other well-respected economic analysts.

That The Fed is claiming that total losses will less than half my best-case figure and one quarter of the IMF’s stretches credibility – and that’s being polite.

Now on to methodology:

The participating BHCs were asked to estimate their potential losses on loans, securities, and trading positions, as well as pre‐provision net revenue (PPNR) and the resources available from the allowance for loan and lease losses (ALLL) under two alternative macroeconomic scenarios.

Note: They asked the banks, they did not send in a team of examiners to look at the books independently. So the base data that was ingested into this process in fact came from the banks themselves, not from independent, outside examination. As a consequence it is fair to ask where the valuations came from and how they are supported, including the models and other information used to develop these figures.

This data is not disclosed.

…

Runner-ups:
- Lessons of the Financial Crisis for Banking Supervision by Ben S. Bernanke
- New fund, old fundamentals from The Economist
- More Banks Will Need Capital by Damian Paletta and Deborah Solomon
- Stress Tested: Has Geithner’s Bank Confidence Game Worked? by Massimo Calabresi

Related posts from the blog:

• Articles of the week (17/2009): Investment Strategies That Work
• Articles of the week (15/2009 & 16/2009)
• Article of the week (23/2009): The Crisis and How to Deal with It
• Article of the week (14/2009): My Manhattan Project
• Article of the week (25/2009): Have stock markets run away from reality?