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http://www.moneymorning.com/2009/04/13/china-industrial-output/ ...
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Stress Testing the Stress Test Scenarios: Actual Macro Data Are Already Worse than the More Adverse Scenario for 2009 in the Stress Tests. So the Stress Tests Fail the Basic Criterion of Reality Check Even Before They Are Concluded
Nouriel Roubini | Apr 13, 2009
The spin machine about the banks’ stress test is already in full motion;
some banking regulators have already leaked to the New York Times the spin that all 19 banks who are subject to the stress test will pass it, i.e. none of them will fail it.
But if you look at the actual data today macro data for Q1 on the three variables used in the stress tests – growth rate, unemployment rate, and home price depreciation – are already worse than those in FDIC baseline scenario for 2009 AND even worse than those for the more adverse stressed scenario for 2009. Thus, the stress test results are meaningless as actual data are already running worse than the worst case scenario.
The FDIC and Treasury used assumptions for the macro variables in 2009 and 2010 both the baseline and more adverse scenarios that are so optimistic that actual data for 2009 are already worse than the adverse scenario. And for some crucial variables such as the unemployment rate – that is key to proper estimates of default rates and recovery rates (given default) for residential mortgages, commercial mortgages, credit cards, auto loans, student loans and other banks loans – current trend show that by the end of 2009 the unemployment rate will be higher than the average unemployment rate assumed in the more adverse scenario for 2010, not for 2009! In other terms, the results of the stress test – even before they are published – are not worth the paper they are written on as they make assumptions on the economy that are much more optimistic –even in the worst scenarios that the FDIC has designed - than the actual figures for Q1 of 2009.
Description of the FDIC stress tests baseline and more adverse scenarios
To see why actual 2009 are already even worse than the more adverse scenario of the FDIC let us first look at how the stress tests are done:
According to the FDIC there are two scenarios, one a more optimistic “baseline scenario” for 2009 and 2010 for the three macro variables (GDP, unemployment, and home prices) and one more pessimistic one - the “alternative more adverse scenario”. The baseline scenario assumes – based on the average of the forecasts by the consensus of macro forecasters at the time when the stress tests were announced – that GDP growth (percentage change in annual average) will be -2.1% in 2009 and +2.0 % in 2010, that the unemployment rate will average 8.4% in 2009 and 8.8% in 2010, and that home prices will fall 14% in 2009 and 4% in 2010 (percentage change fourth quarter of the previous year to fourth quarter of the indicated year based on the Case-Shiller, 10-City Composite index). In the alternative adverse scenarios GDP growth is assumed to be -3.3% in 2009 and 0.5% in 2010, the unemployment rate is assumed to average 8.9% in 2009 and 10.3% in 2010 while home prices are assumed to fall 20% in 2009 and 7% in 2010.
The description provided by the FDIC of the stress test also shows graphs – but not actual figures – for the quarterly behavior of the three macro variables in 2009 and 2010 for both scenarios. Based on these quarterly graphs in Q1 of 2009 the unemployment rate would approximately average for the quarter 7.7% in the baseline scenario and 7.8% in the adverse scenario; the GDP growth rate (4-quarter % change) would be -1.9% in the baseline scenario and -2.1 in the adverse scenario; while home prices would fall in Q1 relative to Q4 of 2008 by 4% in the baseline scenario and by 7% in the adverse scenario.
How do these scenarios actually stack with actual figures for Q1 2009, with current consensus forecasts and with current likely paths for these macro variables?
Unemployment rate
Take the unemployment rate: in March of this year the actual unemployment rate was already – at 8.5% much higher than the baseline scenario for Q1 (7.7%) and even higher than the adverse scenario 7.8%. Even if you were to take the average unemployment rate in Q1 that was 8.1% this figure is already well above both the baseline and adverse scenario.
If one has to look ahead the likely evolution of the unemployment rate in 2009 and 2010 will lead to actual data that are much worse than the baseline and more adverse scenarios. For example, based on current trends in employment and initial claims Ted Wieseman, US fixed income economist for Morgan Stanley and a very mainstream analyst, has recently argued that the unemployment rate could reach 10% by June of 2009;
as he put it:
The key round of early March economic news was weak, with another disastrous employment report again standing out. Non-farm payrolls plunged 663,000 in March, bringing the average drop over the past five months to 667,000, an unprecedented run of job losses in absolute terms and the worst in percentage terms over such a period since the 1973-75 recession… The past week’s jobless claims report showed substantial deterioration as we move towards the survey period for the April employment report, so at this point there is no reason to expect the extremely weak recent trend in the jobs report to show any improvement next month. Indeed, at the rate jobs are disappearing, the unemployment rate could be into double-digits as early as June (bold added).
Indeed with per month job losses well above 600K for several months in a row and with initial claims still averaging 650k per week for the last few weeks there is no chance that job losses will be any less than 600K for the next two months.
Even if the economy were to turn to positive growth by Q3 – as the consensus forecasts expects – the unemployment rate would rise for at least another 12 months as job market data are lagging indicators of economic activity. For example, in 2001 the recession was short and shallow – only 8 months – and over by November but job losses continued for another 19 months until August of 2003. So based on current trends – and even generously assuming that the economy recovers positive growth by Q3 of 2009 (quite an heroic assumption) it is almost certain that the unemployment rate will be 10.5% by December of this year (and would thus average about 9.5% for the year); in a more adverse – but more realistic scenario – the unemployment rate would reach 11% by December of 2009 and average 9.8% for the year.
So in summary, based on current actual data the unemployment rate is already well above the values that the FDIC had for them in Q1 of 2009 in both the baseline and stress scenarios. And given current trends in the unemployment rate and initial claims for unemployment benefits – even assuming that the economy behaves like the consensus forecasts and recovers positive growth in H2 of 2009 – the average unemployment rate in 2009 would be 9.5% that is not only well above the baseline scenario of 8.4% for 2009 but also well above the average unemployment rate for 2010 in that baseline scenario. Worse, 9.5% would be even worse than the average unemployment rate that is assumed by the FDIC for 2009 in the adverse scenario, i.e. 8.9%. Actually based on current data for initial claims it is highly likely that by April 2009 (this month) the unemployment rate will reach 9.0% and thus be higher already at this early part of 2009 than the average of 8.9% that the FDIC assumes it will be for the average of 2009.
Since based on current and likely trends the unemployment rate will be – at best over 10% by year end – and more likely closer to 11% by year end (and average 9.8% for the year) 2009 data are already worse than the adverse scenario and will for sure be worse than the adverse scenario. But more importantly by year end 2009 the actual unemployment rate – even with a growth recovery in H2 – will be higher at 10.5% - than the average unemployment rate assumed by the FDIC in the adverse scenario for 2010, not 2009!
GDP growth
A similar analysis suggests that the FDIC assumptions for GDP growth and home prices are already worse than the adverse scenario – let alone the baseline scenario – for Q1 of 2009. A first estimate of Q1 2009 GDP growth will be out only at the end of April 2009 but the current consensus is that the figure will be around -5% for the SAAR figure in Q1 (i.e. the growth rate of the economy in Q1 2009 relative to Q4 of 2008 seasonally adjusted at annual rate) with a number of respected and reputable forecasters putting that figure at -6% or even worse. Now, based on the FDIC graphs the GDP growth rate (4-quarter % change in Q1 2009 relative to Q1 2008) would be -1.9% in the baseline scenario and -2.1 in the adverse scenario. If we plug the current consensus estimate of Q1 GDP growth and then compute the y-o-y 4-quarter % change we get a figure of -2.3%. Thus, based on consensus estimates of GDP for Q1 2009 the 4-quarter contraction of GDP will be – in Q1 of this year – already worse than both the baseline scenario figure (-1.9%) and the more adverse scenario figure (-2.1%). If, as possible, the GDP contraction in Q1 is -6% (SAAR) the Q1 2009 vs Q1 2008 percentage change in GDP will be -2.5%, a figure even worse than the previous one compared to the baseline and more adverse scenarios for Q1 of this year. So by Q1 of this year both the unemployment rate and the GDP growth rate are (or will likely be once the Q1 GDP first estimates are out) worse than the FDIC figures for both the baseline and more adverse scenarios.
Moreover, relative to the time in December when the consensus forecasts for 2009 were used by the FDIC to derive its baseline scenario for 2009 such consensus forecasts have significantly worsened. Based on the latest March figures the consensus is now projecting that 2009 GDP growth will be -3.2 rather than the -2.0% in the original FDIC baseline. And a number of high profile mainstream sell-side research such as Goldman Sachs, Merrill Lynch, Morgan Stanley - houses – that have had a better than average track record in forecasting the current downturn – are now forecasting a 2009 GDP contraction of about 3.5% on average (the current RGE Monitor forecast is even worse at 3.7%). Thus, the current consensus forecast for 2009 GDP growth is – at 3.2% - practically identical to the adverse scenario GDP growth for 2009; and most reputable research institutions are forecasting for 2009 a figure that is actually worse than the consensus scenario. Also, while the current consensus forecast for 2010 growth (2.0%) is practically identical to the baseline scenario for 20010 GDP growth (2.1%) a number of more accurate than consensus source are predicting a much weaker scenario for 2010: for example Goldman Sachs has a current forecast of 1.2% for 2010 GDP growth as opposed to the baseline scenario figure of 2.0%. So, in all likelihood even the current consensus forecasts is close – or worse – than the more adverse scenario while the baseline scenario is already out of the window both for Q1 and the year overall.
Home prices
Let us now consider the outlook for home prices. Unfortunately the Case-Shiller 10-City Composite figures are available – for now – up to January 2009 with the February figures due to be published at the end of April. The FDIC baseline assumes that home prices will fall – December 2009 vs December 2008 – by 14% while its more adverse scenario sees home prices falling by 22% during 2009. The fall in home prices in January 2009 relative to December 2008 was 1.9% that – if continuing at this rate for all of 2009 – it compounds to an annual rate of 25.3% that is well above the 14% of the baseline scenario and also above the adverse scenario of 22%. One month does not make a trend and the 12-month % change in home prices was a negative 19% in January 2009, December and November 2008, up from the 18% drop in August-September-October 2008 and the 17% drop in the May-June-July 2008 period. So, in the last year the rate of home price depreciation has accelerated from 17% to 18% to 19% and most recently to 25%. It is possible that the rate at which home prices will fall for the rest of 2009 will be smaller than the latest 25% rate. But even the more recent optimistic data for the housing sector – a possible stabilization of housing starts, building permits, new home sales and existing home sales – do not imply that the rate of fall of home prices will be significantly lower in the months to come. The reason is that, while home sales and housing starts/completion are now showing signs of stabilization – after falling from their peak by more than 70% - the excess supply of new and existing homes is still huge – both in absolute terms and as a ratio of sales – and thus a significant downward pressure on prices. Even if housing starts/completions were to go to zero – from their current 500K level – it would take about 11 months until the current supply of new homes is depleted by the current demands. And since a recovery of both supply and demand from current depressed levels would reduce the excess inventory only if new home sales are well above new completions, there is no reason to believe that home prices will fall at a much slower rate for the rest of 2009. In other terms, even if quantities in housing were to stabilize and then recover in the next few months prices will keep on falling for all of 2009 and for all of 20010 at a very rapid rate.
Also, research done by RGE suggests that – based on a variety of criteria such as real home prices, home price to rental ratios, home price to income ratios, price affordability measures of homes in 2009 and 2010 home prices will fall much more than the baseline scenarios of the FDIC – that sees a cumulative fall in home prices in 2009-2010 of 18.5%. These criteria suggest that home prices will cumulatively fall by a figure very close – if not higher – than the one assumed in the more adverse scenario, i.e. 30.5%.
In summary, home prices have been falling in recent months at a rate that is much higher than the 14% assumed in the FDIC baseline for 2009. They are also running currently at an annual rate that is higher than the 22% in the more adverse scenario of the FDIC; and even considering actual figures for the last few months – that show an accelerated rate of fall in homes prices between the spring of 2008 and the most recent data – home prices have been falling in the last few months at rates – average of y-o-y and m-o-m figures – of about 20% with an upward trend in the data. So the actual and trend figures are well above the baseline figure of 14% and closer to the 22% of more adverse scenario.
Conclusion: Actual macro data for 2009 are already worse than the more adverse scenario in the stress tests. These are not stress tests but rather fudge tests
In conclusion, recent data and trends for the unemployment rate, GDP growth and home prices show that, as of Q1 of 2009, actual macro data are much worse than the baseline scenario of the stress tests and even worse than the more adverse scenario of the stress tests. Under the most reasonable scenario the unemployment rate by the end of this year will be worse than not just the baseline and more adverse scenarios for 2009 but it will also be even worse than the average unemployment rate for all of 2010 in the more adverse scenario. Similarly GDP growth figures are running – in Q1 2009 – at likely rates that are already worse than both the baseline and the more adverse scenarios. While home prices are currently falling at rates that are much higher than the baseline scenario and close to those of the more adverse scenario.
And for some crucial variables such as the unemployment rate – that is key to the proper estimation of default rates and recovery rates for every type of bank loans – current trend show that by the end of 2009 the unemployment rate will be higher than the average unemployment rate assumed in the more adverse scenario for 2010, not for 2009! In other terms, the results of the stress tests – even before they are published – are not worth the paper they are written on. The stress test exercise was already flawed from the start as it took as its baseline scenario the consensus forecast for the economy for 2009 and 2010, a consensus that, for the last two years, had totally gotten wrong not only the growth rate of the economy but even the sign of the growth rate as the recession started in December 2007. And the more adverse scenario of the stress test was not really a truly adverse scenario as it assumed positive growth for 2010 (rather than an additional negative growth for 2010) and assumed an average unemployment rate for 2010 in the more adverse scenario that, based on current data and trends, is likely to be reached at the earliest by Q3 of 2009 and at the latest by Q4 of 2009. So how can anyone take seriously stress tests that are blatantly rigged from the outset with scenarios that make little economic sense and that, based on actual current data, are already obsolete as their worst case scenario is already more optimistic than actual current data for Q1?
This financial crisis was one due to opacity and lack of transparency in financial markets and due to regulators that were asleep at the wheel. But now the administration officials and regulators have decided to add to the fog of opacity by adding to the lack of transparency in financial markets: regulatory forbearance that allows banks such as Well Fargo to declare charge-off rates and to set aside reserves for loan losses that make no sense relative to the state of the economy and relative to their loan book; partial suspension of mark-to-market accounting that allows – starting with Wells Fargo – to hide losses and reduce the amount of write-downs on securities; likely reinstatements of some variant of the uptick rule that will restrict shorting of stock and will artificially boost equity prices (a form of legalized manipulation of the stock market by regulators that are trying to prevent short-sellers to do their job, i.e. make stock prices reflect fundamentals and prevent bubbles in stock prices); and now stress tests that fail the basic test of a reality check by making assumptions – that even in the worst case scenario that is designed from start to be too mild to be a sensible realistic stress test scenario – that are obsolete based on actual data for the economy as of Q1 of 2009. Call it a generalized “fudge test” rather than a true “stress test”.
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