The Stress Test Facts

April 24, 2009

Authored by: Robert Klingler

On April 24, 2009, the Federal Reserve published a white paper describing the process and methodologies employed by the federal banking supervisory agencies in their forward-looking capital assessment of large U.S. bank holding companies.  The white paper is thin on new details, but does provide a base for understanding the stress tests being undertaken of 19 bank holding companies with total assets in excess of $100 billion.

Purpose and Effect of the Stress Tests

The stress tests are designed as the first part of the Capital Assistance Program to demonstrate which institutions the government believes will need to raise additional capital.  If a stress test demonstrates that an institution requires additional capital, the institution will be required to enter an agreement to issue convertible preferred securities to the U.S. Treasury in an amount sufficient to meet the capital shortfall under the TARP Capital Assistance Program.  Each such institution will then be permitted up to six months to raise private capital in public markets to meet their capital needs, and would be able to cancel the obligation to the government without penalty.  Participants would also be given the opportunity to convert their existing TARP Capital Purchase Program preferred stock into the convertible preferred stock to be issued under the TARP Capital Assistance Program (such a conversion would not affect the institution’s Tier 1 capital, but could affect the institution’s tangible common equity and their dividend obligations).

Timing/Results

The Treasury has stated that it will release the overall results of the stress tests on May 4, 2009, including “some” company-specific information.  We understand that officials are debating how much information to provide about specific institutions, but that they will at least reveal which firms need to raise capital and how much, with a goal of that all results are presented on a comparable basis.

Risk Assessment Plus

At the end of the day, the stress tests are not significantly different than each institution has historically done as part of its ongoing risk assessments (other than the consequences if more capital is needed).  However, the program is designed to simultaneously assess the 19 largest bank holding companies using a common set of macroeconomic scenarios and a common conceptual framework.  Theoretically, this approach allowed over 150 senior supervisory officials to apply a consistent and systematic approach across the group to evaluate the estimates provided by the 19 firms.

Economic Scenarios

As previously announced, the Stress Test used macroeconomic forecasts available in February 2009 to determine a “baseline” and “more adverse” economic forecast of GDP, unemployment and housing prices.  The baseline numbers were intended to represent a consensus view about the depth and duration of the recession, while the alternative “more adverse” scenario was designed to reflect the possibility that the economy could be “appreciably weaker.”  In its latest white paper, the Federal Reserve emphasizes that the “alternative test” is not, and is not intended to be a “worst case” scenario; arguing that in order to be useful, the stress tests needed to reflect conditions that are severe “but plausible.”

Economic Scenarios: Baseline and More Adverse Alternatives

There have been significant concerns expressed that the economic scenarios were not sufficiently dire.  For example, the February unemployment numbers now show unemployment of 8.5%, already in excess of the baseline projections.  The white paper acknowledges that the economy has deteriorated since the initial scenarios were developed, particularly with regard to unemployment levels.  However, the report notes that “although the likelihood that unemployment could average 10.3 percent in 2010 is now higher than had been anticipated when the scenarios were specified, that outcome still exceeds a more recent consensus projection by professional forecasts for an average unemployment rate of 9.3 percent in 2010.”

Estimates

Each participant was required to estimate, under both the baseline and more adverse alternative, estimated loan losses for 12 specific loan categories, as well as estimates of the institution’s pre-provision net revenue (net interest income plus non-interest income less non-credit related expenses).  In addition, firms with trading assets of $100 billion or more were required to estimate future losses on their mark-to-market portfolio under the more adverse alternative. (The stress test appears to presume that no additional losses would be required in the trading portfolio if the baseline scenario transpired as the trading assets should already reflect current market prices, which assuming an efficient market, would reflect the baseline scenario.  No discussion is made of whether such a presumption is valid under existing market conditions.)

The Federal Reserve’s white paper indicates that the regulators provided a set of indicative loss rate ranges for 12 specific loan categories under the conditions of the baseline and the more adverse economic scenarios.  Participants were allowed to diverge from the range, but only if they could provide evidence that their estimated loan losses were appropriate, especially if they fell below the range minimum.  Participants were also permitted to further subdivide the 12 loan categories.  The ranges were derived from “a variety of methods for predicting loan losses, including analysis of historical loss experience at large bank holding companies and quantitative models relating the performance of individual loans and groups of loans to macroeconomic variables.”

The 12 loan categories are:

  • First Lien Mortgages – Prime
  • First Lien Mortgages – Alt-A
  • First Lien Mortgages – Subprime
  • Closed-end Junior Lien Mortgages
  • Home Equity Lines of Credit
  • Commercial and Industrial (C&I) Loans
  • Commercial Real Estate (CRE) Construction Loans
  • CRE Multifamily Loans
  • CRE Nonfarm, Non-residential Loans
  • Credit Cards
  • Other Consumer Loans
  • Other Loans

Details on Loan Loss Estimates

We still don’t have a lot of details. The white paper does not provide the ranges of indicative loss rates under either the baseline or more adverse alternative for any of the loan categories.  However, a recent Wall Street Journal article states that “banks would have to calculate two-year losses of up to 8.5% on their first-lien mortgage portfolios, 11% on home-equity lines of credit, 8% on commercial and industrial loans, 12% on commercial real-estate loans and 20% on credit-card portfolios, according to a confidential document the Federal Reserve gave banks in February that was viewed by The Wall Street Journal.”

With regard to first and second lien mortgages, participants were required to provide detailed and uniform descriptions of their portfolios, including type of product, loan to value ratios, FICO scores, geographic location, level of documentation, year of origination and other features.  FICO scores, loan to value ratio bands, date of origination, product type and geography were all found to be “strongly predictive of default.”

For commercial real estate loans, participants were required to provide information on property type, loan to value ratios, debt service coverage ratios, geography and loan maturities, which was then fed into both industry vendor models and newly developed proprietary models to generate independent loss estimates for each portfolio.  For construction loans, the white paper indicates that the geography and nature of the project received “special attention.”

Resources