Stress Tests: FAIL

by Larry Levin

Although the stress test results are due to be released Thursday, as I predicted, some leaking has spilled out early. Today we received word that four major banks took the stress test and their grades were a big fat F.

Wells Fargo and PNC Financial Services were among four lenders mentioned today that will need to raise more capital; however, for these two no dollar amount of additional capital was mentioned. Test taken, grade F.

The report says that Shitigroup needs to raise an additional $10 billion. In response, Shitigroup says it is considering a plan to convert more than $15 billion in trust preferred shares, a hybrid of debt and equity, into common stock, the Financial Times reported. Test taken, grade F-.

Bank of America was also mentioned in the report; it is need of more than $10 billion. Some analysts were immediately quoted as saying this isn't a problem because BofA could increase capital through sales of businesses such as First Republic and Columbia, and investments such as China Construction Bank. Test taken, grade F-.

The market responded like a true 21st century touchy-feely teacher handing out grades: A+ for everyone. After all, we wouldn't want to hurt Shitibank's self-esteem; it may develop a complex. Citibank closed +8.8% today, PNC +14.1%, BAC +20%, and WFC closed up 23.7%.

Outcome based education meet Wall Street.

What's really scary is that these "stress tests" should have been very easy to pass. When the New York State Insurance Department issued a memo to all New York authorized insurers last year, it told insurers to conduct stress tests assuming extreme scenarios: "Interest rate shocks, equity market shocks, yield curve shifts, changes in credit quality and liquidity, rating agency downgrades, collateral calls, and large-scale catastrophes." However, the bank stress tests do no such thing. They rely exclusively on mild scenarios.

Shouldn't the worst case scenario for unemployment be the depression-era peak level of 25%? That sounds like a real test to me. However, in the outcome based tests administered by the Fed & Treasury the "worse-case" scenario is 8.9% in 2009 and 10.3% in 2010. What a joke! By this Friday the probability of unemployment reaching 9% is very high and I doubt that will be the worst for 2009. It's only May.

Shouldn't the worst case scenario for GDP be the 1932 contraction of 13.0%? But in the bank stress tests, the so-called "worse-case" scenario is a decline of just 3.3% in 2009 and only 0.5% in 2010. Uh-huh, real difficult test. The current trajectory is for GDP contraction of 5-6%.

Corporate bond default rates are absolutely critical in order to estimate the severity of future default rates on bank loans and derivatives; and Moody's has recently projected that they will exceed the levels of the Great Depression. However, in its report released Friday on the bank "stress" tests, the Fed makes no mention whatsoever of corporate bond default rates.

In the end, the stress tests were a joke as many have already said. The results will be whatever the Treasury wants - period. Sadly, even though the tests should have been easy to pass, the Treasury claims the four aforementioned large banks failed.



Previous Day's Trading Room Results:

Trade Date: 5/4/09

E-Mini S&P Trades*
(before fees and commissions):

1) FT buy @ 10:20am at 893.25 = -1.50 (1 lot)

2) OTF buy @ 10:50am at 892.25 = b/e (1 lot)

3) Algorithm positions (3)...combined Secret's and Algo total...-4.00


Electronic (YM) Mini-Dow:

1) None today



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