Bank ‘stress test’ draws fire from critics

John W. Schoen Senior producer • Profile • E-mail

The Treasury’s “stress test” for the U.S. financial system sounded like a good idea at the time. But as officials wrap up and begin disclosing the results, some critics are giving the entire process a failing grade.

Treasury officials say the comprehensive analysis of the assets on the books of 19 of the largest U.S. banks will help identify which institutions are at the greatest risk of failure if the recession deepens. By applying scenarios that simulate the impact of, say, a higher unemployment rate on mortgage defaults, the government is hoping to target aid to the banks that need it most. The test results could force banks deemed at risk to set aside more capital to cover future losses.

The idea is flawed, critics say, and the exercise has done little to shore up battered bank balance sheets and investors' confidence.

“The stress tests are, at best, a waste of time,” said Mike Holland, who heads the investment firm he founded. "At worst, they're misleading and testing the wrong things. The idea of using some level of unemployment to say whether Citigroup is not as strong as JP Morgan to me is laughable. And therefore I will be glad when this process is over."

Bank regulators are hoping to quell concerns about the stress test by releasing details Friday of how they’re being performed and offering guidance on how the results should be interpreted. The final results are expected to be made public May 4.

Investors will be looking closely at the Treasury's assumptions. Given the complexity of the mortgage-backed assets the computer models are analyzing, there is already skepticism about how any model can forecast and identify potential problems.

“I would argue — as others have — that a lot of (banks') models have been badly flawed in the last few years anyway, which is why they're in the mess they're in,” said Yra Harris, a currency trader with Praxis Trading.

It’s also not clear just how “stressful” the Treasury’s models are. Critics says it's as if your doctor tried to gauge the health of your heart by setting a treadmill to a leisurely stroll.

Even if the test is vigorous, they argue, it doesn’t guarantee that the road ahead won’t turn out to be steeper than expected or subject to falling rocks.

There’s little doubt U.S. banks face some serious stress ahead. On Tuesday, the International Monetary Fund estimated that U.S. financial institutions could suffer $2.7 trillion in losses from the global credit crisis, nearly double its projection six months ago. U.S. banks have written down about $510 billion in assets, putting them about halfway through the process of loan loss recognition, according to the IMF. Another $550 billion in write-downs is expected over the next two years.

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