Stress Test Dummies: It's All About Interest Rate Risk, Right?

There's a skeleton in everybody's closet

I can think of one or two in my own room

But I would like to introduce them both to you

You'd shake their bony hands and so dispell the gloom


"The Ghosts That Haunt Me"

Brad Roberts/Crash Test Dummies (1991)

Once again it is time for the Federal Reserve stress tests for major US banks, which were released last week.  This exercise is not so much about financial stability, to borrow the title of my new upcoming book, as it is about “confidence.”  The Fed stress tests are mandated by the ill-considered “Dodd-Frank Wall Street Reform Act” or “DFA,” which is of course not about reform so much as about screwing up the US economy.  To get a sense for what the DFA, as the Fed calls it, is doing to housing, have a look at my presentation to the Five Star Institute tomorrow.

The first hint of problems with the stress tests is the fact that the Fed is focused on capital instead of issues like transparency and fraud.  For those of you who were in cryogenic sleep during the 2008 financial crisis, the market breakdown was caused by securities fraud rather than a lack of capital.  As I discussed in Breitbart last week, “Washington & Wall Street--Memo to GOP: Fed Losses Are Good News:”

First and foremost, let’s talk about why the Fed has been buying hundreds of billions of dollars’ worth of Treasury paper and MBS for the past several years. Back in 2008, when the subprime crisis exploded into the consciousness of global investors, the markets suddenly realized that the U.S. balance sheet was out of balance to the tune of tens of trillions of dollars. Toxic subprime paper created by the monopoly of big banks and government-sponsored entities such as Fannie Mae and Freddie Mac, and hidden via “off balance sheet” fraud, suddenly came rushing back into view and onto the balance sheets of U.S. banks. 

Horrified investors fled the market for Treasury securities and MBS. Eventually, Fannie, Freddie, AIG, and, ultimately, Citigroup had to be rescued by the U.S. Treasury. The serious imbalance between assets and liabilities was illustrated by then-Treasury Secretary Hank Paulson, who famously announced in 2008 that Citigroup was insolvent and that we needed a “Super SIV” scheme to buy the toxic assets from the largest banks, including Citi, JPMorgan, and Bank of America.  

It was the fact of some $60 plus trillion in hidden, fraudulent toxic waste that nearly crated the global economy.  A lack of capital in US banks had nothing to do with it.  Now that the FASB has essentially outlawed most (but not all) off-balance sheet games, the banks are earnings and revenue constrained.  The DFA restrictions on housing finance are a big part of why large bank earnings are going to be an ongoing disappointment.

The second clue that the DFA stress tests are a bad joke is the continued insistence by the Fed on using three macroeconomic scenarios to define the test process.  Anyone even vaguely familiar with financial analysis understands that you don’t need an economic narrative or an economist for that matter to stress test a financial institution.  You start with loss assumptions, examine capital, earnings and liquidity, and then assess the loss absorption potential of a given institution.  

The participating banks have noted in public comments on the DFA stress tests that the Fed and other agencies “do not have a strong record of identifying emerging risks in the past, and that the scenario variables were not sufficiently plausible to be useful as a risk management tool.”  These comments are well founded and illustrate the silly nature of this exercise.  The fact that the Fed has required bank management to spend time on this idiocy while closing year-end financial statements is just another piece of evidence that nobody at the Fed is living in the real world.

Another reason that the Fed stress tests are not to be taken seriously by investors is the dependence upon risk modelling, a requirement that is designed to provide employment to economists, lawyers and risk managers.  Not only do the banks need to spend time and money modeling meaningless macroeconomic scenarios, but they are also meant to include “regional variables” in the analysis.  Since the “the paths of any additional regional or local variables that a company used would be expected to be consistent with the path of the national variables in the supervisory scenarios,” this whole process is ridiculous.  But, again, investors in large banks should bear in mind that this process is about “confidence,” not the ability to absorb loss.

The next indicator that the DFA stress tests are not to be taken seriously is that the inmates – that is, the large banks – are still being allowed by regulators to select the loss variables for the test.  Indeed, the stress tests manage to ignore truly relevant real world risks while pandering to the management of the largest banks.  

For example, a real world test would be to ask the top five banks to stress tests a 50% write down of all second lien exposures on 1-4 family mortgages over a 24 month period. Since the major rating agencies have already identified second liens as the next “surprise” for the big banks, you would think the good people at the Fed would be asking that question.  But no, the stress tests instead allow the participating banks to each select their own stress tests factors, thereby assuring that the tests will have no consistency or comparability from one bank to the next. 

Another area of stress that the Fed seems happy to ignore is interest rates,  a factor that is a direct result of quantitative easing or “QE.”  The US banking industry faces trillions of dollars’ worth of duration risk due to the Fed’s aggressive manipulation of interest rates over the past several years.  The baseline, adverse and severely adverse scenarios in the DFA stress tests do not begin to address this concern, but at least the regulators have asked the banks to structure their thinking accordingly.

Whether US banks are able to accurately model their interest rates risk as part of the DFA stress tests is not really a relevant question since the banks are probably no better at this sort of risk modeling than the regulators.  The relevant question is why neither the Fed nor their sponsors on Capitol Hill admit that the continued fiscal dissolution of the US government is the chief source of risk to the US economy.

It may not matter whether the Federal Reserve System loses money as a result of a gradual change in interest rates over the next year and more.  But you can be sure that the US equity markets are going to react – and probably soar – when the crowd of happy campers now packed tightly into the crowded trade in bonds starts to head for the exit. Concepts like option adjusted duration may even be heard again as banks manage the largest shift in interest rate risk seen the “sucker bond” trades of the 1990s.  Does Askin Capital Management or Kidder Peabody ring any bells?

But you can be sure that you won’t hear about second liens, interest rate risk or anything else of this nature before the fact from our beloved friends at the Federal Reserve Board. Remember, the definition of “systemic risk” is when markets are surprised.  But this reality, despite past experience,  does not seem to affect the thinking of the members of the Federal Open Market Committee, where ignorance is truly bliss.


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