What the Stress Tests Didn't Tell Us

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Shannon Stapleton / Reuters

Government "stress tests" on 19 of the U.S.'s largest banks, showed Bank of America will need about $34 billion to cover potential capital shortfalls

U.S. authorities have just released the results of the stress tests that they ran on the top 19 U.S. banks. This group holds about two-thirds of the total assets in the U.S. banking system. The health of those balance sheets has profound implications for the severity and length of this global synchronized recession.

Don't be comforted by the results. That's because two different scenarios are used to stress test the balance sheets of financial institutions: baseline and adverse scenario. The baseline was designed to represent the consensus at the time in which the plan was presented. Unfortunately, current macroeconomic conditions are already worse than the adverse scenario (which is closer to the new consensus) for all the three variables of the test —unemployment, real GDP and home prices. (See TIME's "25 People to Blame for the Financial Collapse.")

Take the unemployment rate: the adverse scenario of the stress test is based on an average unemployment rate of 10.3% for 2009. However, at the current pace unemployment is more likely to hit the 11% mark. On a quarterly basis, the rate of unemployment is already well beyond the levels assumed by the adverse scenario for the end of the first quarter of 2009. Similar considerations apply to U.S. real GDP and home prices. (Read about the top 10 bankruptcies.)

The results of the tests did not carry any surprises with respect to what was leaked to the press in the past few weeks. Ten of the institutions participating in the Supervisory Capital Assessment Program (the stress tests) will have to work to raise capital in the months ahead.

So what can be taken away from the stress-tests exercise? That even lenient stress tests show that several large banks still need additional capital. Beyond that, there are more questions: Will the capital-requirement prescription unveiled by the stress tests be enough? And how will banks prop up their balance sheets?

The answer to the first question is no. Recapitalization needs will likely exceed what the current stress tests suggest since macroeconomic conditions are bound to be worse than the consensus anticipates, making the adverse scenario of the stress tests look mild. At this point in time, banks are still facing well over $1 trillion in losses over the next couple of years, even if low short-term interest rates make new loans very profitable. Moreover, according to RGE Monitor, real U.S. GDP growth will inch back into positive rates only toward the end of 2009 rather than at the beginning of the second half the year. That spells ongoing problems among borrowers.

Answering the second question — repairing bank balance sheets — is neither simple nor clear-cut. What is clear is that the capital needed will not come (entirely) from private hands. Banks and policymakers will essentially have a few different options: banks can issue more common stock; policymakers can push more conversions of preferred shares (or liabilities) into tangible common stock of the troubled banks; or more capital can be injected using taxpayers money, effectively taking control and (partially) nationalizing the banks.

The first and second options will likely be pursued again. Shareholders won't welcome the dilution but they will get over it.

The third option, injecting more taxpayer money, might not be an option by itself if the remaining TARP funds end up not being enough; the costs for the taxpayer are too high and the political capital behind such a solution is too weak.

Moreover, the specter of insolvency might be looming for some institutions. That calls for a plan to treat zombie banks, one that does not involve more taxpayer money again. This is why it is imperative that Congress proceeds to pass new insolvency-regime legislation to allow for orderly receivership of complex financial institutions.

The paradox in all this is that the less market-oriented solution might ultimately be the most efficient and market friendly. Taking over troubled financial institutions for a short period of time and separating the bad part of their business from the good part of their business — cleaning them up — will likely arouse investors' interest and reduce uncertainty enough to attract capital.

The final lesson from all this is that the U.S. and global credit markets are still impaired, and more disruptive uncertainty lies ahead. The economy is still very weak, and while the pace of contraction in real activity is slowing, the global contraction is going to be with us for a while longer. Indeed, a global recovery is conditioned on the health of the U.S. financial system. And even after the stress tests, the health of that system is still in question.

The author is head of global research at RGE Monitor in New York City.

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