Stress Test?

Posted on: by .

The market continues to struggle to push higher and the broader indices came under pressure yesterday. The VIX is still pricing in an either/or scenario. If we solely listen to politicians and Keynesian leaning economist, the economy is recovering and everything is great, but is it?

Stress Test?

I have previously been critical of the bank “Stress Test” we have been through since the credit crisis, primarily because it is a very arbitrary test that never looks at the bottom line, as well as omits some critical factors. I guess one could argue my criticism is unfair, since the US (as well the West) use a factional-reserve banking system that is also reliant on a central bank and it is all based on a fiat currency. Yet, I think my core criticism remains valid, so let me briefly review.

Fractional Reserve?

Banks in the U.S. use a fractional reserve system. This system allows a bank to loan out far more than they actually have on deposits. That is because a bank is able to COMBINE its actual deposits with central bank money (or credit). Because a bank is able to loan out MORE than it actually has on deposit, this can create the risk of a “Bank Run”. A “Bank Run” is when the people withdraw their money in mass from the bank, which can cause a collapse of the system. There are supposed systems to protect the banks from a “bank run” and other risks, part of this safeguard is that the bank MUST have a certain amount of money on hand as their reserves, which is a fraction of the amount of deposits and loans. These reserves had been between zero and 5%. The bank can also, if they fall below those reserves, borrow directly from the Federal Reserve – this is known as borrowing from the “Discount Window”. However, a bank borrowing from the “Discount Window” is admitting that it not only has a problem, but most likely heading into default.

Courtesy of

Credit Crisis breaks the bank!

The credit crisis showed us how weak this fractional reserve system is and that it is somewhat a house of cards. Banks first started running to the Fed’s “Discount Window” as there reserves fell and we actually saw some banks face a “Bank Run”. Pretty soon almost every major bank was borrowing from the Fed’s “Discount Window” and then eventually it all came crashing down. TARP, TALF, and other bailouts were needed to prop up this house of cards.

If it ain’t broke…

Yet, after this massive failure, which required extraordinary measures from the Federal Reserve and government bailouts, no one asked the question; “Does a Fractional Reserve Banking system with Fiat Currency actually work?” Instead they decided the problem wasn’t the system, but that banks didn’t have ENOUGH money on reserves.

It was decided that the banks should undergo a “stress test”, technically some “what if” scenarios. Many banks failed, some passed, but another concern that some raised, was whether this “stress test” was any good. Several economists and bank experts pointed out flaws in the stress test and the results. Regardless it became the law of the land and it was ultimately decided to raise the reserves, rather than fix or change the system.

A few years after the crisis, as of December 2011, the bank’s reserves were set at what they felt were appropriate levels.

Banks with dollar transactions below $12 billion do NOT need reserves.
Banks with dollar transactions between $12 – $80 billion needed to have a liquidity ratio of 3%.
Banks with dollar transactions over $80 billion had to have a liquidity ratio of 10%.

There was a lot of complaining, mainly that banks would not be able to profit as much if they needed to have more money in reserves. The Federal Reserve help eased the pain by keeping both the Discount Window and Fed Funds rate as close to zero as possible, this reduced the expense for having to keep these reserves and also help boost margins on bank lending.

All the complaints, concerns, and criticisms about the “Too Big to Fail” was never really addressed. Sure there was a massive chunk of legislation passed called the Dodd/Frank Act and then there was the Consumer Protection Agency and a host of other things, but all-in-all it was more red-tape, expansion of government, and ton of compliance and legal related issues. The fast growing job sector in the financial world became compliance to deal with the litany of new rules and many of them conflicting. However, what was really never addressed what the fundamental risk of the system, banks remain Too Big to Fail and the only real issue to address risk was to RAISE the liquidity ratio. Big deal, now instead of 5% it only takes 10% “Bank Run” to bring it down.

Government Banks

If you had been following the Market Preview you know I have recommended stay totally away from investing in some of these banks, mainly Citigroup and Bank of America. It is not that I am bearish, it’s just they are so deep in the government bed, face constant legal action, are so convoluted and expansive that one can’t make any REAL accurate judgment if they are making money, failing, have enough reserve, or what. No I don’t think they are going out of business, the government will not let that happen, but I also don’t want to invest in them.

Citigroup was such an epic failure it reverse split their stock 10:1. The stock had fallen to below $5 during the crisis, which triggered all kinds of problems. One main problem was that many investors, including retirement accounts, were not allowed invest (buy) stocks that traded under $5 dollars (based on Brokerage Firm regulations). Additionally, it was a moral back-breaker to the company, shareholders, and even those that bank with them. The reverse stock split turned the $5 stock into a $50 stock overnight. For each 10 shares of $5 stock you received 1 share of $50 stock. It’s mostly eye candy and it is well known on trading floors that a “reverse stock split” is the death knell for many. Citigroup stock has been a horrible investment, even after the stock split – it has flailed between $3 to $5 dollars a share since the crisis, sorry I forgot $30 – $50 a share.

Courtesy of

Fed’s Stress Test themselves?

So today we are given the latest and greatest stress test results, but before we get to that, I am very happy to report that the Federal Reserve conducted their own stress test on themselves and passed. The Fed used two internal economist from their ultra-conservative Federal Reserve Bank in San Francisco (where Janet Yellen once hailed from) to conduct the rigorous and detailed examination. It found that even with over $4 trillion in liabilities, sorry I mean assets on it’s balance sheet (but not any off balance sheet considerations), funding banks via the Discount Window, buying $100s of billions of mortgage back securities annually, and buying $100s of billions of US treasuries annually, that everything is secure, fine, and there is nothing to worry about. Well that is good news, so now it is time to review the banks.

Courtesy of mylearningnetwork

Stress Test Extreme?

The EXTREME scenario to Stress Test these banks are; a U3 unemployment rate to 11.2%, a drop of 50% in the stock prices, and decline to 2001 home price levels. I personally would not see that as an “extreme”, but rather a “realistic” possible scenario. An extreme would also need to take into consideration not just basic general conditions that we recently experienced, but also; inflationary risk (perhaps to 1970s levels of 20%) and Fed Funds at 10% at the very least. Add those two components and most banks fail. Of course the Fed, who not only conducts this test, but tested themselves, is NOT considering REAL inflation a problem or that the Fed Funds rate would increase (not even to normalized levels).

Citi Fails, go figure.

Five banks failed the “Stress Test”; among those was of course Citigroup. Even Bank of America and Goldman Sachs initially fell short of the minimum requirement, but after reducing their planned dividend payment and share buybacks were able to get their head above water. Citigroup could do nothing, no dividend increases, no share buy-backs; nothing could save them from failure. The five that failed now have 90 days to address their weakness and then can resubmit their share-buybacks and dividend increases. Three of the banks that failed were foreign banks with a US presence. HSBC North America and RBS Citizens, failed because of “inadequate governance and weak internal controls”. Irony was that HSBC was one of the few banks that did NOT get a bailout and actually fared well on their own through the crisis.

Citigroup is of course getting hit in the pre-market after their highly public failure last night.

Lesson Learned?

What general lesson can we learn from this? Don’t invest in Citigroup and expect the unexpected. I think the “Stress Test” to a limited extent is useful, but it doesn’t consider other REAL WORLD scenarios as the Fed, who conducts the test, does NOT see inflation as an issue. Additionally, since they also control the Fed Funds rate and Yellen has made it clear (or has she?) that Fed-Fund rates will be at zero for a long time, that it should not be considered. Perhaps she should ask Fed Chair Volcker how that worked from him in the late 1970s (note: He took rates up fast and hard to 20% of try to avoid hyper-inflation).

“That men do not learn very much from the lessons of history is the most important of all the lessons that history has to teach.” – Aldous Huxley

Support & Resistance

INDU 16,000 – 16,500
This morning the futures seem to be mixed, up or down is likely and I don’t see a trend today. Expect intraday volatility.

NDX 3600 – 3700
This index has fallen out of bed and looks to open lower. I would look at 3550 area for a support and a bounce if we get down there intraday. The more important question is can we get above and hold above 3600 by the end of the day?

SPX 1840 – 1880
We will most likely check the 1840 level today, but will we hold that level, is it support? The VIX, a representation of risk, is itself uncertain. It is certainly not at levels (below 13) that would indicate a strong confident rally and it is not at levels (above 16) that would reflect a panic.

RUT 1160?
The RUT looked like crap yesterday. It was as if someone turned off the order flow to the general market and everyone was heading for the door. It closed on the low around 1160 and I wonder if we can get above that and hold strong. If not I think 1140, 1120, and even 1100 are certainly in the cards. I am not sure where confidence comes in and as I always say the RUT is the best gauge of general market order flow.

Real World?

I think the people, investors, and the market as a whole is losing some faith in the story about the strong recovery the government continues to peddle and the Fed continues to refer to. The problem is that their words don’t jive with their actions. Additionally not all the economic data looks as rosy as we are lead to believe.

Yesterday I pointed out the spin zone headed by CNBC economics (Keynesian) reporter, Steve Liesman who didn’t fudge the CNBC economic survey, but certainly did his best to present it in a rosy fashion (see yesterday’s Market Preview).

How much longer can the headline numbers, revisions, and “seasonal adjustment” paint a rosy picture that has decoupled with the reality on the ground?

I do remain bullish in commodities, some equity sectors, emerging markets, gold, silver, and strong blue chips with solid fundamentals and balance sheets. I also am bearish on ultra-high P/E ratio stocks and general equity inflation. I am also concerned about the mounting hidden bubble of inflation and dollar devaluation.

Today’s stress test doesn’t give me that much confidence, especially what it doesn’t measure. If Citigroup and Bank of America can’t even pass (what I humbly believe) as a low hurdle stress test, without having to do some account juggling and refiling, how do you think they will fair in a real-world crap storm?

Comments are closed.