Tuesday, February 17, 2009

Banks Insolvency is not about Stress Tests

Over at Marginal Revolutions, Alex Tabarrok notes that " Many of the major banks are insolvent", and links to NYTimes article here.

Actually, the article notes that if a 'stress test' is applied to banks, using 2 years of future losses, then these banks are near insolvent. They pulled in a credit firm, CreditSights, to generate the stress test. They produced some really large losses, like which generates some really large numbers, like $119B for Wells Fargo, which isn't inconceivable given they have about $1.3 Terabucks on their balance sheet.

But invsolvency is not "insolvency under a stress test", any more than you can say someone is "dead" if they are dead assuming they were run over by a bus. Further, without any details on the stress test, you might as well say "I pulled this number out of a monkey's butt--but I can still give you three significant digits!"

What where the default and recovery rate assumptions? What assets had mark-to-market losses in the stress tests. Break them out by product type to sufficient level of granularity (eg, a subprime loan where the owner has no equity is different than a conforming mortgage where the owner has a 50% equity stake). Without such additional information, their numbers are meaningless.

3 comments:

Plamen said...

Paul Krugman, generosity incarnated with OPM, said on C-SPAN (while touting his book), that in his estimate at least 5 of the top 10 US banks would not pass a stress test. So, what are the options for Geithner:

1) Pronounce several big banks dead, certainly Citi and BoA, and thus cause a credit constipation way worse than the one that followed Lehman's collapse, or
2) Apply a stress test that is nothing of the sort, and go back to Paulson's shtick - save banks, and not the banking system.

I know which one I believe, and so I took my profit in SKF at $180 a share.

Eric Falkenstein said...

Clearly a good call. I clearly missed this whole contagion thing, but I think it is a runaway panic, exacerbated now by huge policy uncertainty. If the Treasury wants to kill banks, they can do it. They don't have to, but they can always say they would have died anyway.

randian said...

Why would you want to intentionally stress banks? It's a stupid idea. Consider on the other side, a homeowner with a 30 year fixed mortgage. Even if the house is now worth less than the mortgage, the bank can't call the loan so long as they payments are being made. Besides, why would the bank want to? You'd just be turning a performing asset into a non-performing one by needlessly throwing the homeowner into foreclosure and possible bankruptcy.