A Look at the New Fed Stress Tests

November 27th, 2011
in econ_news

Econintersect: The Federal Reserve has ordered the 31 largest banks in the draw-and-quarterU.S. to respond to a new set of stress tests to demonstrate their ability to withstand another severe recession if one were to occur starting in the current quarter. The banks must respond to this request by January. This is actually an extension of a stress test program started in November 2011 for the 19 largest banks. The new list includes all banks with assets greater than $50 billion and captures some global banking concerns such as HSBC. The$50 billion cut-off is specified in the Dodd-Frank Act.  Click on graphic for larger view of a really stressful test.

Follow up:

From CNN/Money:

The stress tests require banks to see how they would hold up under such conditions as the stock market crash in 2008 and major declines in global economic activity, including an unemployment rate of 13%. The tests will also include scenarios that incorporate a financial crisis in Europe.

Banks will need to show that they can maintain a buffer of at least 5% of their capital on the sidelines, for times of economic stress.

Banks have until Jan. 9 to submit their plans to the Fed. Those that fail the tests may not be allowed to distribute dividends.

Perhaps the most interesting details in the latest announcement are the stress details showing the shocks that the fed is asking the banks to withstand. These were not made public earlier. The stress defines parameters that would accompany a hypothetical recession starting this quarter. (Remember the tests were designed one year ago.) Econintersect has selected four parameters to examine specifically: stocks, home values, GDP and unemployment. These are displayed graphically with comparisons made to the two most recent prior recessions. The numbers on the x-axis are for the sequential quarters, starting with 1Q/2001, 1Q/2008 and 3Q/2011.


The four graphs show that the stress test involves a similar stock market decline to that associated with The Great Recession and the other three metrics to be worse.

A little more perspective can be obtained from a graph at Calculated Risk that shows the entire data window from the Fed stress test document for stocks and for housing:

Click on graph for larger image.


From this graph it is seen that the global stock market takes a deeper loss that also lasts longer than the 2007-2009 swoon.  And home prices are seen to go back to 2001 levels, a decline of more than 50% from the peak and a further decline of more than 20% from here.

When home prices are adjusted for inflation and a deeper history is examined there is another informative graph from Calculated Risk that goes back to 1976:

Click on graph for larger image.


We now see that, in real terms, house prices under the stress test scenario would go back to levels last seen in the 1980s.

The following graph, originally from The New York Times and anotated by Steve Barry for The Big Picture shows home price data constructed by Prof. Robert Shiller of Yale University going back to 1880.  This data is also adjusted for inflation.

Click on graph for larger image.


Note: Econintersect assumes the differences between the Calculated Risk graph and The NYT graph comes from two different inflation adjustment references.

The Shiller data indicates that the price level projected in the stress test would be that which was seen for most of the post World War II period with the exception of three bubbles, two of then quite moderate and the most recent musch larger.

The non-bubble price level  since WW II (about $110,000) is only a few thousand dollars above the average for 1880-1910 (about $100,000).  However, both levels are far above the prices  of the 27 years between the end of WW I and the end of WW II.    For most of those years inflation adjusted home prices were between $70,000 and $80,000.  Should a realistic stress test have considered home prices dropping by 50% from current levels to match the previous experience?

Sources: CNN/Money, Federal reserve press release, Calculated Risk and The Big Picture

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