Friday, April 24, 2009

The No-Stress Tests

All of you know that the death knell for the financial sector has been ringing in my head for quite a long time. I will cut to the chase: the Fed, OCC, OTS, FDIC and Treasury Department have done a splendid job by reassuring the patient with heart disease they are in great shape since their heart rate while sitting down and watching the fish bowl is right in line. The test instructs banks to consider a baseline scenario and a more adverse scenario when valuing their portfolios.

Real GDP

-2% & -3.3% for 2009

2.1% & 0.5% for 2010

The last reading for annualized real GDP growth was -6.34% and the average growth rate since the start of the recession is -0.71%. This represents a small correction considering the employment loss that has been experienced in the same time frame. My guess is that corporations delayed inventory corrections, thinking that the slowdown would pass.

Declines of 2% and 3.3% in real GDP for all of 2009 bring the economy back to where it was in the 2nd quarter 2006 (almost to the penny) and late 2005 / early 2006 respectively. I have mentioned in previous posts that the U.S. would need to dial back to 2005 levels to begin clearing the decks for a recovery. This would represent a drop of 4.6% from 4th quarter, 2008 GDP. Therefore, at the very least, the more adverse scenario should be a number less than -4%.

Recoveries are notoriously hard to predict, 2010 is a long way off in some respects. The U.S. has a history of bouncing back quickly after economic slowdowns. Given a correction back of 2005 levels, I would consider the more adverse scenario of 0.5% acceptable. Breaking 2% will be difficult in my opinion. I just don't see what industry will snap America back (and maybe that is why America does recover so quickly!).

Civilian Unemployment Rate

8.4% & 8.9% for 2009

8.8% & 10.3% for 2010

This number has been steadily increasing (8.5% was the most recent print) and 8.9% seems easily surpassable. The average for the 1st quarter of 2009 is 8.1%. Unless something radically changes, I think we will hit 9% by June and the rest of the year will pull the average unemployment rate to 9.1%. Remember, this is supposed to be a "stress" test. It is not supposed to be a "what could certainly happen, within the realm of possibility" test. In 2007, few people thought the events of 2008 would have transpired.

Once again, the more adverse scenario for 2010 seems acceptable. Once again, a baseline of 8.8% is assuming the typical U.S. recovery.

House Prices

-14% & -22% for 2009

-4% and -7% for 2010

This is a tricky one. The benchmark chosen for this input is the Case Shiller 10 City Composite. The index print from 12/08 was 162.12 and the percentage declines for 2009 are based off of that number. Price declines have been accelerating, dropping at a 19.4% year over year rate (January, 2009 report). A drop of 14% from the 12/08 print would bring home prices back to 2002 levels. This seems reasonable to me, as does the more adverse case. The 2010 levels seem appropriate as well. However, this is highly sensitive to the employment picture. On average, the entire country is upside-down on their mortgages. This leaves little margin for error on the side of public policy.

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