BUSINESS

Five Reasons The Bank Stress Tests Are Unreliable

06/08/2009 05:12 am ET | Updated May 25, 2011

A simple guide to why the stress tests weren't stressful enough:

1. The stress test allows for a debt-to-net capital ratio of 25 to 1. That is far higher than the 12 to 1 ratio that the SEC required of banks before a fateful decision in 2004 to allow the five largest investment banks to increase those ratios. That decision helped lead to their decision to take on more leverage, including making large bets in subprime mortgage bonds, spurring the current financial crisis.

2. The 8.5% loss rate for commercial real estate portfolios is likely too generous. Default rates have quintupled since the beginning of 2008 and experts say it is just the beginning of that market's collapse.

3. The earnings we saw in the first quarter will be tough to repeat. Several of the banks benefited from one-time events, and the industry is also benefiting from cheap money from the Fed.

4. According to the Wall Street Journal, skepticism is also in order because the government is allowing some banks to simply shift more of their capital to common equity, rather than raise new money. This is despite the fact Wall Street has shunned bank stocks for most of this year, with banks like Citigroup, for example, seeing its shares drop under $1. "The government is effectively saying most large banks were solidly capitalized even when investors fled earlier this year," the WSJ reported.

5. The government is relying on the banks to determine their risk-weighted assets, which we are going to have to take at face value. This measurement can also leave out unrealized losses on some securities, which the banks could be forced to mark down in the future.

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