Last week, when the US Treasury unveiled the basics of its lender "stress
tests", the Federal Reserve concluded that "most US banking organizations
currently have capital levels well in excess of the amounts required to be well
capitalized". Simultaneously, they also claimed that the banks needed more
capital. Apparently the Fed has little understanding of irony.
Why would our central bankers conclude that "well capitalized" banks need "more
capital?" Quite possibly, they believe, as I do, that the rosy economic
assumptions that form the basis of the "stress tests" may be far too
optimistic. I believe that neither the Fed nor the Treasury has any will to
paint a clear picture of our
financial turmoil. But that won't stop them from operating under those
assumptions.
A brief examination of the stress test assumptions shows why the Fed should be
hedging their bets.
First, the level of stress in the tests was set unrealistically low. Their
absolute worst case assumption was for a gross domestic product (GDP)
contraction of only 3.3% in 2009. This comes as first quarter 2009 GDP shrank
at 6.1%. And the economy is still slowing. To post a contraction of just 3.3%
for the year would likely involve an immediate reversal in the rate of
contraction and outright expansion by the fourth quarter.
The stress test also assumes a worst case scenario unemployment rate of 8.9% in
2009. This is also wildly optimistic when unemployment is already at 8.7% and
rising at some 20,000 each day. Worse still, if calculated on a pre-Bill
Clinton administration basis, to include all those unable to find anything but
part-time employment, the current unemployment rate is a staggering 19.2%, or
just 0.8% from official depression levels! It appears that the US is fast
slipping from recession into depression, rendering the stress tests almost
meaningless other than as a public morale boosting exercise.
Second, the conclusion that "most" of the banks are well capitalized, as the
Fed claims, also strains the bonds of credibility. The 19 banks tested have
total assets of US$11.5 trillion. Technically, 16 of these banks already are
insolvent. If any two fail, they will exhaust the current Federal Deposit
Insurance Corporation bank deposit insurance fund. Only three of the banks,
accounting for just 6% of the group's assets, could survive even the most
liberal worst case scenario assumed by the Treasury. Meanwhile, the five
largest and most vulnerable banks, with about $8 trillion in assets, account
for some 70% of the group's total assets.
Some observers point to the relative security of the smaller regional banks,
which did not engage as heavily in leveraged investments. However, the FDIC
list of troubled banks has risen in the past three months from 1,568 banks with
about $2.3 trillion in assets to 1,816 banks with some $4.4 trillion in assets.
The risk has almost doubled, seemingly overnight!
Finally, by suspending the needed discipline of mark-to-market accounting, the
profits of many banks have been massaged deceptively upwards. For example, a
"real" loss of more than $2 billion at Citibank was "fudged" into a published
profit of $1.6 billion.
The observers at the Fed and Treasury, as well as the most sophisticated
investors around the world, are neither ignorant nor ill-informed. Despite
their stress tests, they must be aware of the possibility of massive bank
failures and terrifying aftershocks.
This belief may have been a factor in a rumor, circulated after the stress
tests were announced, that defensive maneuvers to avoid a run on the dollar,
including the elimination of hedged short sales against the dollar, would soon
be announced. If such a rule were to be put forward it would rightly be seen as
a precursor to internationally coordinated foreign exchange controls, that
would abruptly bring an end to the benefits of free trade.
Meanwhile, China has used its huge domestic gold production to double its gold
reserves. Such clear concern over the viability of paper currency may encourage
other central banks and even corporations to follow suit, making physical gold
even harder to obtain. Gold therefore, is likely to experience renewed buying
pressure as panic buying overcomes the downward 'commodity' selling pressure of
depression.
John Browne is senior market strategist, Euro Pacific Capital. Euro
Pacific Capital commentary and market news is available at
http://www.europac.net.It has a free on-line investment newsletter.
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