Stress and the debt test

Roubini and Richardson explain why the stress tests aren’t valid:

he International Monetary Fund has just released a study of estimated losses on U.S. loans and securities. It was very bleak — $2.7 trillion, double the estimated losses of six months ago. Our estimates at RGE Monitor are even higher, at $3.6 trillion, implying that the financial system is currently near insolvency in the aggregate. With the U.S. banks and broker-dealers accounting for more than half these losses there is a huge disconnect between these estimated losses and the regulators’ conclusions.

The hope was that the stress tests would be the start of a process that would lead to a cleansing of the financial system. But using a market-based scenario in the stress tests would have given worse results than the adverse scenario chosen by the regulators. For example, the first quarter’s unemployment rate of 8.1% is higher than the regulators’ “worst case” scenario of 7.9% for this same period. At the rate of job losses in the U.S. today, we will surpass a 10.3% unemployment rate this year — the stress test’s worst possible scenario for 2010.

The IMF numbers confirm something that I picked up in going over documents from the Federal Reserve and the Bank of International Settlements. While the subprime mortgage bubble may have been the initial trigger for the crisis, it was a very small portion of the much larger credit bubble and the ongoing resolution of the smaller problem will not suffice to solve the larger one.

I took the liberty of modifying an IMF chart which compared the various outstanding loan categories by separating out the subprime loans from 2003 to 2008 based on a Goldman Sachs report. Regardless of whether one looks at outstanding loans or the securities based upon them, it’s quite clear that the subprime market is not, and never was, the major part of the problem, much less the totality of it. The fact that the total amount of derivatives is still increasing demonstrates that the financial sector has not exited the casino, but rather is going double-or-nothing courtesy of the taxpayer’s backing.

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