Stress Less Over Stress Tests

What does the latest round of Fed stress tests tell us?

96.6%—a clear “A” grade for the financial system, as 29 of 30 big US banks tested by the Fed passed their annual big bank stress tests. Yet some pundits are still stressed out—effectively accusing the Fed of grading results on a curve. Others seem to find the results calming. In our view, both sides stress the tests too much. (As, it seems, does the Fed—they were so stressed they had to publish a minor correction nearly immediately after the initial results were published.) Stress tests using virtually any criteria are just too arbitrary to actually indicate whether banks can weather a future economic crisis. There isn’t much here data-wise for investors to sink their teeth into. But the split reaction to the results illustrates where sentiment is today—mixed between skepticism and optimism—more fodder for the bull!

Stress tests began after the 2008 global financial panic, as an effort to restore some folks’ faith in the solvency of the banking system. Given the sentiment backdrop when they were first deployed—in May 2009—these tests may have actually helped sway sentiment to a small degree, helping boost confidence in banks. But four years later, they seem to be somewhat of an unnecessary exercise. Fears over the finances of the biggest American banks just aren’t running rampant any longer—in fact, they’re a bit hard to come by. Nowadays, it seems to us a little more like ticking a box, for the most part.

Like past years, last week’s test tried to gauge whether America’s biggest banks (those with more than $50 billion in assets) currently have sufficient capital buffers to weather a hypothetical market meltdown of arbitrary shape and size. They’re deemed to pass if they meet the Fed’s (also rather arbitrary) minimum 5% tier one capital ratio. In this go round, only Zions Bancorporation failed, with a 3.6% tier one common capital ratio. But Zions’ failure is tied largely to its early issues with the Volcker Rule. The Fed’s test reflects Zionsoriginal estimation of the writedowns Volcker would force on its approximately $629 million of Trust-Preferred collateralized debt obligations. That was before regulators watered down the provision, which Zions now estimates will cause losses of only $135-145 million.

While the actual results of the test were nearly uniformly positive, reactions were far more mixed than the results. Some critics believe the test criteria isn’t strict enough and claim they create a false sense of security—the assumptions are too loose and don’t account for factors like banks’ borrowing costs spiking or credit freezes. If we were to actually experience an economic crisis, they claim, these results wouldn’t much resemble the actual effect. Yet others view these results as a sign of improved bank health. These contradictory views are emblematic of broader investor sentiment, which is still stuck between skepticism and optimism—a sign the bull has plenty more room to continue.

Counterintuitive as it may seem, in our view, both the skeptics and optimists are right. Stress tests are indeed arbitrary—they won’t predict the next economic crisis because they can’t predict causes. How banks fared in this exercise says nothing about how they will fare in reality. For one, consider the Fed’s assumptions for a “severely adverse hypothetical scenario”: Real GDP falling -4.75% between Q3 2013 and year-end 2014, unemployment spiking at 11.25% by mid-2015, stocks falling nearly 50%, house prices falling 25% and inflation slowing to less than 1% y/y. Setting aside the fact these numbers have no relationship to current reality, we can see why the Fed chose them—they look a bit like the last bear market, when the S&P 500 fell -57% from peak to trough,[i] real GDP fell -4.3%,[ii] home prices declined -25.0%[iii] and the unemployment rate eventually peaked at 10.0%.[iv]

But who knows whether the next downturn will look anything like that! Or have anywhere near the impact on bank balance sheets as the last one, which was magnified by mark-to-market accounting requirements for illiquid, held-to-maturity assets. Those requirements don’t exist today. You also can’t really stress-test things like the Fed’s bungling bailouts of failing banks. While it isn’t impossible, it is unlikely two successive recessions are tied to the same cause. We could easily be testing the Financials sector only to see the driver of the next recession emerge from a totally different economic segment. Or a force outside the US. Or, or, or.

At the same time, banks are far healthier today than five years ago, just as the optimists point out. Capital levels are higher, loan charge-offs are down, ROI is rising, lending is up, and earnings are growing. All of which we’d know without stress tests, but hey, whatever helps the Fed sleep at night.

Ultimately, though, a right-minded investor is better served viewing the two camps' reactions to the test results than the results themselves. If there were no skeptics, if the reaction was either a uniform shrug or a uniform cheer of “Huzzah!,” then that might be one indication sentiment is getting a bit stretched. In that way, today’s divergent views are a sign this bull has room to run.

[i] FactSet, as of 12/2/2013. S&P 500 Price Level Return, 10/9/2007-3/9/2009.

[ii] Federal Reserve Bank of St. Louis, as of 3/24/2014. Real GDP, 10/1/2007-4/1/2009.

[iii] Federal Reserve Bank of St. Louis, as of 3/21/2014. S&P Case Shiller 20-City Home Price Index, 10/1/2007-3/1/2009.

[iv] Federal Reserve Bank of St. Louis, as of 3/21/2014. Civilian Unemployment Rate, seasonally adjusted, 10/1/2009.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.