Federal Reserve Releases Stress Test-Liars Poker 2013

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Are you better off than you were four years ago? Okay, okay, I know this has become another trite little saying hauled out during political campaigns. But this time there is a bona fide reason to ask the question.

U.S. Federal Reserve Chairman Ben Bernanke gestures as he speaks at a Joint Economic Committee hearing on the economic outlook, on Capitol Hill in Washington
Federal Reserve Chairman Ben Bernanke

The folks at the Federal Reserve released their findings of their annual “stress test” on the nations 18 largest Bank Holding Companies,(in government acronymical fashion- the BHCs). In the aftermath of the global financial meltdown in 2008, Congress passed the Dodd-Frank law which among other things requires the Fed to create all kinds of statistical models to determine what would happen to our largest and most sacred financial institutions if all hell broke loose on Wall Street and other financial centers. As you will recall, when hell actually broke loose in 2008, it was both cause and a reflection of systemic problems of the worst economic downturn since the depression of the 1930s.

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No Easy Assignment

Now creating a really valid stress test is a heavy task to fall on any shoulders less equipped than the United States Federal Reserve. However, even for such a noble institution as Fed Chair Ben Bernanke’s group, to “get it right” the first time is nothing short of a herculean task. How many scientific attempts did it take for the United States to launch a rocket into orbit? In the final analysis, the Fed’s job is modern day rocket science. Ironically, both Christopher Dodd and Barney Frank, co-sponsors of the law, retired from Congress and got out of town. What do you think they knew?

In releasing its report on March 7, the Fed stated that the results “…provide a unique perspective on there business of the capital positions of these firms because they incorporate detailed information about the risk characteristics and business activities of each BHC and because they are estimated using a consistent approach across all the BHCs, providing comparable results across firms.” This of course is untrue since each of the so-called 18 BHCs have a substantially different range of financial services and thus a substantially different risk profile. For example, Wells Fargo is about as close to what we would consider a traditional bank as any of the 18 BHCs. On the other side, both Goldman Sachs and Morgan Stanley are traditional investment banks. The exposure of an investment bank can easily be 5 times greater than their traditional banking counterparts.

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Bernanke, President Bush, Treasury’s Hank Paulson in 2008

Let’s put this into a real-life example. Leading up to the 2008 meltdown, commercial banking regulations permitted about a 10:1 capital risk ratio. For example, if a bank like Citibank had $100 dollars in depositor accounts, it could make $1,000 in investments like loans and so forth. If ever that ratio became greater than regulation (a unexpected withdraw of depositor funds) the commercial bank could borrow from the Federal Reserve.

An investment bank on the other hand could leverage its balance sheet to as much as 50:1, which is what companies like Bear Stearns and Lehman Brothers were doing just before their demise. Since investment banks could not rely on depositors for capital, they generally relied heavily on borrowed capital. Especially in the case of Bear Stearns, they relied on so-called “overnight money”. Literally every night Bear Stearns borrowed billions of dollars from lenders with the promise to repay the following morning. No one could ever argue that this was real capital. It was simply intended to satisfy regulators. Investment banks cannot borrow from the Federal Reserve. From this it is easy to see what a house of cards the world was dealing with in 2008. As soon as investments that Wall Street investment banks favored, like highly illiquid Credit Default Swaps etc., began to sour, overnight lenders cut off the flow of billions of dollars; and just like that Bear Stearns set off the biggest financial crisis of modern times.

In fairness, the Fed has devised stress measures for guys like Goldman and Morgan Stanley that take into account the vastly different business models at work on Wall Street. The whole point of Dodd-Frank is to give the average person both comfort and protection from another global financial meltdown like 2008-2009. However, if you take time to read through the report, you will soon be reminded of the adage that the road to hell is paved with good intentions. It seems that no one is more aware of this than the Fed itself as stated in bold type on page 17 of the report:

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The Federal Reserve’s projections should not be interpreted as expected or likely outcomes for these firms, but rather as possible results under hypothetical, severely adverse conditions. These projections incorporate a number of conservative modeling assumptions, but do not make explicit behavioral assumptions about the possible actions of a BHC’s creditors and counterparties in the scenario, except through the severely adverse scenario’s characterizations of financial asset prices and economic activity.

In God We Trust–The Rest is Hope

Translated into English: Any connection between the 745-page document you are reading and reality is purely coincidental, and when surprises just pop up in the future, hang up and call 911 or go to your nearest emergency room!

So if the task is too complex and the outcome so unpredictable, why waste time stress testing the BCHs in the first place?

The simple answer is that under Dodd-Frank, it is the law. The more basic core issue is faith and confidence. Without these two components, the system ceases to function. If for example, overnight lenders had more faith, Bear Stearns and possibly Lehman may still be alive today. There is nothing that supports the system but faith. Therefore, the Fed is creating a dance with the BHCs that draws to mind that 1970s move called The Hustle. It is less likely to go viral than the Harlem Shuffle, but The Hustle is far more potent.

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Obama and Timothy Geithner

To begin, consider the Fed’s input on which way to perform its test. “The projections were calculated using input data provided by the 18 BHCs and a set of models developed or selected by the Federal Reserve, based on a hypothetical, severely adverse macroeconomic and financial market scenario developed by the Federal Reserve. The severely adverse scenario features a deep recession in the United States, Europe, and Japan, significant declines in asset prices and increases in risk premia, and a marked economic slowdown in developing Asia. The Federal Reserve also applied a separate global market shock to six BHCs with large trading, private equity, and counter-party exposures from derivatives and financing trans-actions.”

Of course we want to believe in the accuracy of all the data submitted by the BHCs. In good economic times there is probably little likelihood that the data is valid. But then, we aren’t really concerned about that. History will note that the financials of Bear Stearns and Lehman Brothers did not reveal the truth until the end.

At least in these cases, there was no motive to shave the numbers.

In his book “Bailout” Neil Barofsky revealed the level of stress on the Fed and on US Treasury Secretary Timothy Geithner to restore faith and confidence in the financial system, especially during the early days of the Obama administration in 2009. The book did a remarkable job in revealing the amount of smoke and mirrors that were required of the newly minted Treasury secretary as he was thrust into a role for which there was literally no script. Perhaps this is the key point to all of the Dodd-Frank stress test efforts. Even with the most accurate available data, the stress test is something of a joke.

Followers of the Faith Beware

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In the past 50 years, financial modeling has increasingly taken over as a means of predicting the future based on the notion that history not only repeats itself but you can get rich believing it. Yes, this is a solid and logical approach to dealing with risk. It uses historical data points as its base. When the practitioners of financial modeling were using it to back test a few stock market strategies, the consequences were limited. However, the past 20 years the application of modeling, even by such MIT scholars as Myrol Scholes, have produced what has become known as “fat tails”. Without going into a tedious explanation of the bell curve and standard deviation, the principal of fat tails is that history does not completely repeat itself. Of late the phenomena of radical deviancy is occurring with both greater frequency and with greater consequence. This came to the world’s attention when the firm created by Scholes, Long Term Capital Management, nearly tipped the world into a financial meltdown in 1998, losing over $4.6 billion in a little more than 80 days. By the way, this is the same person who help create the Black-Scholes model that was used for decades to value corporations.

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Nowhere should this escape the reader’s notice more than the report released by the Fed. So the question, are you better off than you were four years ago, may be quite relevant to today. The stock market is making historic high levels; the average 401K is now worth a few thousand dollars more than at the peak in 2009; real estate values are climbing once again; 237,000 new jobs were created in January (according to the Labor Department). Hell, even spring time is coming, so hope should be springing with it. If you have faith, then the Fed has accomplished its task. As for the rest of us, fat tails are still a cause of concern. Remember that our currency is engraved “In God We Trust.” The Treasury Secretary is a political appointee.

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