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Fair Game

Stress Tests Are Over. The Stress Isn’t.

THE beginning of the end of the banking crisis or merely the end of the beginning?

That is what inquiring Americans want to know after last week’s pronouncement that 10 of the nation’s biggest banks must raise $75 billion by November if regulators are going to give them a clean bill of health.

Bank of America, Wells Fargo, GMAC and Citigroup are the neediest institutions, said government stress testers. Nine others, including Bank of New York Mellon, American Express and U.S. Bancorp, were deemed healthy.

“The results released today should provide considerable comfort to investors and the public,” Ben Bernanke, the chairman of the Federal Reserve Board, said in a statement last Thursday when his office released the Supervisory Capital Assessment Program. He added that nearly all of the tested banks had enough capital to absorb higher losses the Fed expected under its “hypothetical adverse scenario.”

With almost 40 pages of charts, graphs and scenarios, the program was a “deliberately stringent test,” its authors said. Clearly, the message they want to send is that the banking mess we have endured for the last two years is finally becoming manageable.

All is under control. Nothing to see here, folks. Move along.

Much as it would be a relief to move on, anyone in search of reality cannot yet conclude that the big banks are out of the woods. The government tests were, in truth, not exceedingly tough. And some of the program’s “adverse” scenarios look more like a day at the beach.

“Let’s not call it a stress test,” said Janet Tavakoli, founder of Tavakoli Structured Finance, a consulting firm in Chicago. “This was a test to try to get a measure of capital adequacy, using broad-brush percentages. I think what they are hoping is that the banks are going to be able to earn their way out of this.”

Some might be able to do that, given the immense taxpayer subsidies they are receiving. Cheap money from government programs translates to delightfully low expenses and the potential for profits where there might otherwise be only losses.

But not all banks will be able to earn enough to see them through. And while no one knows how long our economy will remain under pressure, Ms. Tavakoli said she was certain that the stress tests’ assumptions on worst-case losses at banks were too rosy.

Under the government’s so-called adverse scenario, for instance, banks may experience losses of 8.8 percent over the next two years on first mortgages they hold. A more likely figure, Ms. Tavakoli says, is 10 percent.

“Given what has happened with the economy and unemployment, they are in massive denial,” she said. Losses recently seen in Fannie Mae’s portfolio support this view. In the first quarter, its subprime loans had average losses of around 68 percent; the Fed expects two-year losses in subprime to be, at worst, 28 percent.

For investors interested in a stress test that is free of government spin, Institutional Risk Analytics, a bank analysis and risk management firm, published its own assessment of financial institution soundness last week. Using first-quarter 2009 reports on 7,600 institutions from the Federal Deposit Insurance Corporation, the analysis showed that banks were under increasing pressure.

Christopher Whalen, the editor of Institutional Risk Analyst, said that the data told him that bank losses would not peak until the end of the year; before he combed through the figures, he had thought losses would hit their highs in the second quarter.

Mr. Whalen said he pushed back his estimate for peak losses because banks continued to provision more for loan losses — the reserves bankers set aside for future damage — than they are actually writing off. “We don’t see charge-offs yet,” he said. “When you see banks charging things off, the reserve bill will have ended. Then, you’ll know you are done.”

In the meantime, taxpayer subsidies to banks will help offset some of the losses, he said. But keeping interest rates in the cellar to revive banks has significant costs, Mr. Whalen said. For example, institutions that have agreed to pay out interest on investments that are higher than prevailing rates — think insurance companies and pension plans — are getting killed. “The Fed can’t do this for much longer,” he said.

What’s more, banks’ costs for working out bad loans — whether mortgages or credit card debt — are rising, Mr. Whalen said. In previous downturns, for example, investors would step up and buy bad credit card debt from banks. Yes, the prices they paid were discounted, but at least the banks could write off the loans and move on.

Now, though, buyers for these hobbled portfolios are so rare, and the prices they will pay so low, that banks are hiring their own workout specialists to recover what they can from troubled borrowers. That costs.

It is good that the stress test circus is over. But two lessons remain. First, the effects of a debt binge like the one we have just experienced cannot be worked off either quickly or painlessly. Second, there is the matter of the government’s credibility deficit. Maybe $75 billion will be enough to pull the big banks through this woeful period. But weren’t some of the folks providing these estimates also those who assured us subprime would not be a problem? That, in fact, it would be “contained”?

Yes, indeedy.

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