'Stress tests' for US banks fail to calm nerves of economists

US REGULATORS are coming under fire after unveiling details of the stress tests facing banks in the coming weeks, with critics charging that the tests are too lenient and will lead to the propping up of so-called zombie banks.

All 19 US banks with assets in excess of $100 billion are in the process of being stress-tested by regulators. These tests will examine how banks would cope under economic conditions as currently forecast as well as a hypothetical worst-case scenario. Banks deemed to be insufficiently capitalised will be given six months to find a private source of capital before being forced to accept government money and ensuing share price dilution.

In the tests, the US government envisages the economy will contract by 2 per cent this year before rebounding by 2.1 per cent next year. Unemployment is predicted to hit 8.4 per cent in 2009 and 8.8 per cent in 2010. House prices, meanwhile, will decline by 14 per cent this year and another 4 per cent in 2010.

The more “adverse scenario” for 2009 sees unemployment hitting 8.9 per cent, a 3.3 per cent GDP contraction and a house price decline of 22 per cent.

For 2010, a worst-case scenario of 10.3 per cent unemployment, GDP growth of 0.5 per cent and a house price decline of 7 per cent is tested for.

The problem, critics say, is that the adverse scenario is just not adverse enough.

“Quite a few private forecasters expect unemployment to top 9 per cent, which makes 10-plus a reasonable possibility,” said Nobel economist Paul Krugman.

On average, economists forecast an unemployment rate of 8.8 per cent by the end of the year – nearly as much as the official “adverse” scenario.

Official estimates look decidedly optimistic when one looks at recent unemployment trends. Already at 7.6 per cent, it has increased by 40 basis points in each of the last two months and is more than 2.7 per cent higher year-over-year. On average, unemployment has increased by 23 basis points per month during that period. By estimating an increase between 0.8-1.3 per cent over the next year, the US government is betting that unemployment growth will slow to just 7-11 basis points per month.

“That would be a pleasant outcome but you have to plan for the worst,” said David Hendler, an analyst at CreditSights.

Krugman is also critical of housing projections, noting price-to-rent ratios are 15 per cent above levels registered in 2000. Housing crashes typically overshoot on the downside, however, meaning the “worst-case” 22 per cent decline is “all too possible”.

Merrill Lynch’s David Rosenberg also sees “an additional 15-20 per cent in downside”. Housing inventory is at record highs, he noted. “It would take two years to bring the unsold inventory down to levels that will allow home prices to stabilise.”

The apparent leniency of the tests has caused many to ask, as BusinessWeek magazine did, if this is “a stress test every bank can pass”.

The US treasury said “the vast majority” of banks had capital “in excess of the amounts required to be considered well capitalised”, although “the uncertain economic environment has eroded confidence in the amount and quality of capital held by some”.

Regulators don’t appear to share investor concerns. Federal Reserve chairman Ben Bernanke this week said that market prices did not reflect US economic fundamentals, while Sheila Bair, chairman of the Federal Deposit Insurance Corporation, said markets needed to “calm down”.

Dean Baker, co-director of the Center for Economic and Policy Research in Washington, said the stress tests “indicate that our economic policymakers are still in a serious state of denial”.

Such sentiments are, unfortunately, familiar to Irish ears. In July, Central Bank governor John Hurley said Irish stress tests showed “the banking system is surviving the turmoil well”.