Projections of future losses may appear closer than they are

May 7, 2009 in Finance,News

AK pointed me toward this piece from The New Yorker, "Stress Test Results: In Line With Other Estimates," which I excerpt here in its entirety. I've bolded the last sentence:

From the moment the Treasury Department announced its plan to stress-test the country’s nineteen biggest “bank holding companies,” the process was dismissed as a whitewash. Critics argued that the tests were not going to be difficult enough, and that, as a result, the projected losses for the banks would be too small, making their balance sheets look healthier than they actually were. But Treasury’s report on the stress tests says that the banks’ total losses through 2010 (including the losses suffered in 2007-2008) could total $950 billion. That’s close to the I.M.F.’s estimate that total losses for U.S. banks from the financial crisis will be $1.1 trillion. And when you take into account the fact that the I.M.F. was estimating losses for all 8000-plus banks in the U.S. system, while Treasury’s number is only an estimate for the losses of the aforementioned nineteen biggest banks, Treasury’s projections look very similar to the I.M.F.’s. That at least suggests that the government used reasonable projections of future losses, and did not, as many feared, rig the tests to make the banks look good.

No, it does not. It suggests that the government's loss projections line up with the current IMF projections and nothing more. Any inference that those loss projections are "reasonable" hinges on the assumption that the IMF's projections are themselves reasonable. And they may be, but let's keep in mind that the IMF's estimate was revised upwards by 25% just last week. Moreover, last spring the IMF expected global GDP growth of nearly 4% in 2009.

I think the safe conclusion is that to this point, the IMF has systemically underestimated the severity of this downturn. (An implausible alternative is that the second derivative has been accelerating downward, but I'm told that in fact the reverse is true. Isn't it fascinating how people embrace calculus when it might be able to resurrect their portfolios?) Barring further evidence, it appears safe to carry that assumption forward. We could say that the stress test affirms the IMF view, or vice versa, but we can make few judgements about how accurate either expectation actually is.

However, my point isn't to argue that the stress test necessarily set the bar too low. I have always held that the stress tests would not give the banks a free pass, because I view the tests as the last opportunity for the executive branch to forcibly inject capital into these ailing institutions. There are two reasons: First, as I've stated here recently, the government can not afford to suggest in any way that the banks are solvent, only to have them incur further massive losses. This would undermine or eliminate the credibility of the Treasury.  Second, I do not think that taxpayers (and, consequently, Congress) are willing to expand the bailout program, which means the only way to force banks to acquire additional capital is via a mechanism that essentially amounts to peer pressure: when the Government announces to the world that you need capital, how can you afford to ignore their claim? The stress tests are a tool to that end, and the result - about half the banks need some amount of capital - is not surprising from that perspective.

Is the test accurate, however? I've made the point before that because the economic assumptions of the test are tracking reality, we may be afforded a rare opportunity to see how close the expected losses mirror reality. Of course, there are major problems with ascribing accuracy to a probabilistic model based on a deterministic outcome, but statistical squabbles aside I'm quite curious to how that plays out.

As for the IMF, their expected result proved so rosy that last week they had add a healthy dose of depression. Maybe now it's depressing enough, or maybe they had it right before - we don't know. But the fact that the stress tests have come out in the same ballpark merely means that industry models, given similar inputs, yield similar outputs. The frustrating conundrum remains: garbage in, garbage out. Models are just the tool (if I use that phrase enough times, maybe people will start to believe it) and in the absence of hindsight we have no basis to judge reason or accuracy.


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