How (not) to design a stress test

April 25, 2009 in Finance,News

Of course the big news of Friday afternoon was the preliminary release of the metrics used in the bank stress tests.  Unfortunately it didn't turn out to be much news at all; few hard figures were revealed and those that were came largely within expectations.  The NYTimes published an excellent copy of the document right here.

One interesting thing which was confirmed was the fact that the baseline scenario is actually quite generous.  It assumes, for example, that the unemployment rate in 2008 will be 8.4%.  Of course, we are presently at 8.5% and despite all the talk of the "second derivative slowing," the first derivative remains steeply negative, implying the unemployment rate will continue to rise.  But this does not mean the baseline case is worthless, as some analysts are suggesting (though, to be fair, it should make us severely question the pass/fail result). Instead, it provides an interesting opportunity to analyze the proficiency of the Treasury's investigation -- if the baseline case tracks reality (or, in this case, understates it), then we can expect the banks' trajectory to mirror the expectation described in the report.  There is speculation that the Treasury will lowball the test and let every bank pass; however if the test looks like reality and banks incur very real losses, confidence in the government's investigative apparatus will be sorely and irreversible undermined.

Another concerning point is the use of "common industry vendor models and developed proprietary models" to generate loss estimates.  These are the same risk models which (depending how you prefer to look at it) absolutely failed to account for the losses the banks have incurred thus far or are being used to arbitrarily mark assets far above their market valuations (courtesy the suspension of FAS 157).  Moreover, these models are used in a conjunction with "monte carlo simulation" that most likely implies the use of Gaussian assumptions.

But what more can we really expect from just 150 professionals asked to do - in one month - the job that couldn't be done by thousands at the various banks.

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