”The last duty of a central banker is to tell the public the truth.”   Alan Blinder, Fed Vice Chairman

 We are sure that if Professor Blinder had known what was coming down the tracks, that he would never have made the foregoing comment on the national airwaves in 1994.

 Last Friday the Fed finally released a document describing the methodology behind it’s the long awaited stress tests (called Supervisory Capital Assessment Program (SCAP)). As you know we have been calling for this triage to be imposed even before the September meltdown of Lehman and AIG (see our previous posts) According to the Fed document the process began in February and focused on banks with assets over $100 billion dollars. According to the Fed there are 19 firms in this group that collectively holds two-thirds of the assets and more than one-half of the loans in the U.S. banking system. Taken together this group supports a very significant portion of the credit intermediation done by the US banking sector.

Full results of how each bank fared are expected to be released by the Fed on Monday, May 4. The SCAP report can be found at:

http://www.federalreserve.gov/newsevents/press/bcreg/20090424a.htm

 However the initial pages of the report make ominous reading for anyone who is hoping for transparency, and more importantly, solutions, to come out of this process. The first sentence of the report states “Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized.” In reading further it did not get any better or more objective, thus significantly heightening our concerns that this exercise is designed to be a whitewash rather than a fact-finding process aimed at measuring the scale and depth of the problem such that appropriate remedies might be devised and implemented.

 The SCAP document goes on to state:  “The SCAP is a forward-looking exercise designed to estimate losses, revenues, and reserve needs for Bank Holding Companies (BHCs) in 2009 and 2010 under two macroeconomic scenarios, including one that is more adverse than expected. Should the assessment indicate the need for a BHC to raise capital or improve the quality of its capital to better withstand losses that could occur under more stressful-than-expected conditions, supervisors will expect that firm to augment its capital to create a buffer.”

Tested firms were asked to estimate potential losses on loans, securities trading positions, off-balance sheet commitments and contingent liabilities over a two-year time horizon. Firms trading over $100 billion in assets were also asked to estimate additional possible trading-related market losses and counterparty credit losses under the adverse scenario based on the market shocks experienced in late 2008. These submissions were then analyzed by supervisors from the Federal Reserve Board, the 12 regional Federal Reserve Banks, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency.

Anyone remotely familiar with the various contortions banks in the US have been going through in order to continue to project a “patina of solvency” to the market, knows that the banking system in the US is insolvent at a macro level. This is why Fed Borrowings have remained at historically unprecedented levels since the latter part of calendar 2007. The relaxation in the FASB 157 rule; a lax attitude by FDIC inspectors and it seems a continued unwillingness on the part of the Fed and the Treasury to admit to the true scale of the problems, add up to the reality that a Giant Bamboozle is Underway.

 Furthermore, with the Federal Government borrowing all the dough on God’s green earth, thus effectively “crowding out” all but the most creditworthy borrowers, it is not clear how Zombie Banks might be expected to raise capital on economic terms and in sufficient quantities from skittish investors.

 The answer to this is found in the nature of the stress tests themselves. The following table compares the “Stress Test” data to the worst recorded previous down cycles:

 On the surface, although the process looks legitimate and thorough, the reality is that the “Stress Tests” are anything but. In comparing the stress data to previous down-cycles one finds that the scenarios tested were not stress scenarios at all. In fact, the recently released GDP numbers show that the US economy is already contracting faster on an annualized basis than in the “More Adverse” scenario. Similarly the Bureau of Labor Statistics has already published unemployment numbers that exceed 13%. The SCAP does not even explicitly incorporate issuer default forecasts in its analysis. This seems strange in the context of a comprehensive risk assessment of lending institutions. We could go on with further criticisms of the process but it would belabor the point.

 What this means is that the magnitude of the continued vulnerability of the banking system to economic weakness will not be revealed; the deposit-making and investing public will not know which banks are in real trouble and no transparent and credible plan to find and apply a solution will ever be found as a consequence of this exercise.

 The whole point of the SCAP it seems has been to obscure the problem and prevent anyone from finding out how bad things really are. Most likely this is because there is significant confusion and debate within the Fed and Treasury and the Administration on the best way forward. These institutions appear to be making things up as they go along.

 Despite our assessment, it is not clear that come Monday the SCAP report will announce a clean bill of health for all 19 Banks. That may have been determined to be too much for the market to swallow. More likely is that some of them will be shown to be at risk, but that on balance the system will be given a “Pass”.

 This amounts to a very risky bet that the economy will improve sufficiently and within a short enough timespan in order to re-float the many sunken US banks that so far no one is admitting to the existence of.

 What this means for investors is that traditional areas of activity – stocks , bonds and real estate – will remain danger zones despite the recent stabilization and/or uptick in prices. The apparent manipulation of this process also suggests that the current positive price action very likely constitutes a Bear Market Rally that should be avoided unless one intends to trade from the long side with tight protective sell orders and the intention of bailing before the music stops yet again.

 In coming months we would not be surprised to see forward thinking investors contemplate entry into markets that are un-correlated with stocks, bonds, and real estate, and to diversify out of US Dollars – buying up commodities, precious metals and other instruments. Despite what US Representative Barney Frank has recently said about America’s largest foreign investor (”They are bluffing!!”), China is already leading the charge away from the Greenback.

  ”The Fed was forced to improvise in the Bear Stearns, Lehman and AIG episodes. These improvised actions have had mixed success”   St. Louis Fed President James Bullard

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