Most Banks Pass ‘Stress Tests’; Economists Harbor Doubts

Published March 15, 2012

The Federal Reserve has announced it believes 15 of the 19 biggest banks in the nation would be safe in the face of a major economic downturn, but do the “stress test” results mean much?

Even though banks have boosted their capital stocks, that doesn’t necessarily mean they’re not at risk, said David Eifrig Jr., a former Wall Street banker who now edits the Retirement Millionaire and Retirement Trader newsletters for Stansberry & Associates Investment Research in Baltimore.

“The most important piece in the news is that these [capital] levels are still below Lehman Brothers when it failed with a Tier 1 capital level of 11 percent,” Eifrig said. “Clearly the capital levels are not that critical one way or the other for long-term safety.”

Tier 1 capital is a measure of how much money a bank has on hand to absorb losses. Lehman Brothers collapsed in 2008 with more than $600 billion in assets, the largest bankruptcy filing in U.S. history.

‘Mostly for Show’

Eifrig said he believes the stress tests “are mostly show, because you can still be leveraged and have high Tier I capital. It seems that this is more a confidence boosting effort by the Fed than any real test of banks’ ability to survive anything. And as an investor in banks you’d have to dig a little deeper in the books to see what their reported asset values really are. I’d like to believe that in 2012, the CFOs are more conservative than ever, but I’m not convinced yet.”

“Stress tests are simulations designed to force banks to rebuild their balance sheets in a particular manner and restore public confidence in banks. I’m a little surprised they allowed four banks to fail in a simulation of their own design,” said economist Mark Thornton of the Mises Institute in Auburn, Alabama.

The Fed’s stress tests required banks to show they would have enough capital to keep lending in the face of a deep recession or financial crisis. The parameters included 13 percent unemployment, a 50 percent drop in stock market prices, and another 21 percent decline in real estate prices.

Unreal Simulations

“Such simulations are not real for two reasons,” Thornton said. “One, the economy could easily experience an unemployment rate greater than 13 percent, the stock market could lose more than 50 percent of its value, and real estate prices could sink by more than 21 percent. Two, those variables might not be the variables that cause banks to fall, or new variables might be a future cause. Future failures might be related to a rapidly falling dollar, the demise of the euro, or the outbreak of war.”

Indeed, Euro Pacific Capital President Peter Schiff wrote in his weekly commentary for investors, “The problem is that the most important factor that will determine these banks’ long-term viability was purposefully overlooked—interest rates.”

Interest Rate Risk

“In the wake of the Credit Crunch, the Fed solved the problem of resetting adjustable-rate mortgages by essentially putting the entire country on a teaser rate,” he continued. “Just like those homeowners who really couldn’t afford their houses, our balance sheet looks fine unless you factor in higher rates. The recent stress tests assume market interest rates stay low, the federal funds rate remains near-zero, and 10-year Treasuries keep below 2%. Why are those safe assumptions? Historic rates have averaged around 6%, a level that would cause every major U.S. bank to fail!

“The truth is that higher rates are the biggest threat to the banking system and the Fed knows it. These institutions remain leveraged to the hilt and dependent upon short-term financing to stay afloat,” he explained.

Ally Financial was the only institution among the 19 to fall short of the Fed’s capital requirements. However, Citigroup, MetLife Inc., and SunTrust Banks Inc. still do not have enough capital to allow them to go ahead with dividend and stock buyback plans, according to the Fed. They must resubmit their capital plans.

Other major banks, including J.P. Morgan Chase & Co., Wells Fargo Co., and U.S. Bancorp, did receive the go-ahead for their dividend and stock buyback plans.