Stress Test Process Raises Big Questions

The results of the government’s stress tests came out Thursday evening, with 10 of the country’s 19 biggest banks being asked to raise more capital, but it doesn’t mean everyone’s a fan of how the tests were done.

“This was a carefully designed, credible test,” Treasury Secretary Timothy Geithner said in a statement accompanying the release of the test results. “The public now has a better idea of how much capital banks will need to ensure they have sufficient capacity to continue providing credit in a more adverse economic downturn.”

He added that “the results are less acute than some had expected, in part because concern about the risk of a more severe recession have diminished, market have improved, and banks, in anticipation of the release of the stress test, have acted in the last few months to increased capital. “

The stress tests were performed to see how these banks, all 19 of which have more than $100 billion in assets each, would hold up if the economy were to experience a deepened, protracted downturn. The assumptions include things like the unemployment rate going to 10.3%, and a decline of 22% in housing prices in 2009 alone.

Robert Shiller, an economics professor at Yale University, told FOX Business that he was concerned the assumptions in the stress tests were not adverse enough, because he thinks the economy could get even worse than that.

Len Blum, managing director at Westwood Capital Management, agreed.

“Just because they call it a stress test doesn’t mean it’s a worst-case scenario,” Blum said. “What if the recession’s a lot worse than we thought?” He said he thought the unemployment and gross-domestic-product assumptions were a little light. He also noted that banks “were allowed to count earnings toward their capital,” which he said was “not reasonable.”

Economist James Galbraith disagreed that the economy would get worse, but told FOX Business he sees an entirely different set of problems with the stress tests.

“I remain skeptical,” Galbraith said. “To what extent did these tests really evaluate asset quality?”

Galbraith said the tests were “well short of the kind of bank examination that we would historically have expected the government to be conducting.” He stated that the asset “quality was basically assumed,” adding that the government didn’t staff the stress tests well enough to look at the quality of the assets.

So, for instance, a bank might be holding a cohort of mortgage-backed securities that it marks at a certain value, when the actual value of the securities might be lower.

Still, many market observers -- including the executives of the banks themselves -- think at the very least that the banking sector will pull through and improve going forward.

Even Bank of America (BAC), which was told to raise the largest amount of any of the 19 banks at $33.9 billion, released a statement with its CEO Ken Lewis saying “we are comfortable with our current capital position in the present economic environment.”

And some thought the stress tests were something of a nonevent anyway.

Shiller said the fact that the government was “taking too-big-to-fail to a massive scale” and saying it would ensure none of the big banks failed was the true decisive event.

The stress tests are “just a side discussion,” he said.