Comments on the
The stress test framework (otherwise known as Supervisory Capital Assessment Program) put out by the Fed Reserve last Friday was brief on details while baseline assumptions are hardly stressful, in our view, with US growth assumption of -2.1% in 2009 and +2.1% in 2010. The adverse case is for growth of -3.3% in 2009 and +0.5% in 2010. In contrast, in the IMF's estimates of writedowns for banks, the base case assumes US GDP bottoming out at -3.3y/y in Q3 2009 with home prices to fall an additional 18% from current levels thru 2010. Hence it appears to us that the Fed's adverse case assumptions are in the region of IMF's base case.
If we recall the IMF stress test, the financial sector losses are expected to reach USD4.1 trillion worldwide (banks, insurers & others). In US, losses are expected to reach USD2.7trn over this cycle, of which USD1.6trn is attributable to US Banks. Based on writedown to-date (USD577bn), the implication is that we are less than half way there in terms of losses at US banks/brokers. We think the IMF's worst case scenario is too daunting to contemplate at this point in terms of resources required.
In this regard the Fed's adverse case may be a good starting point provided the ultimate stress results are presented with more details that suggests robustness of the test. Clearly there is a political dimension to this process, and it appears that the administration is trying to manage with the resources available to it - this will be by converting its preferred shares in banks to common equity and using the remainder TARP funds.
Perhaps there may be a shift in the question from 'How much capital do banks need in a worst case scenario' to 'How much capital do banks need to keep the economy on an even keel' - such a move is not the best of outcomes as it in essence stretches the problem out but may be something that is acceptable to the market and policymakers. Clearly the Treasury/Fed have a more difficult job than the IMF - they can't present the stress test results without the solution.
In this case stretching out the problem rather than paralyzing the markets may be warranted. If we think of the Asian financial crisis, the path to resolution here is more akin to
