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Dan Dorfman

Dan Dorfman

Posted April 28, 2009 | 04:29 PM (EST)

Stressed to Kill?


It's as simple as a, b, c. If you suspect you have heart problems, you take a stress test. Obviously, if your arteries are clogged, you're in trouble and you could die. So it's vital that the doctors conducting these tests do them right.

This stress test issue is especially critical right now since on Monday, the eagerly awaited results of a series of vital stress tests of a different sort -- those undertaken to determine the soundness of the nation's 19 largest banks -- will be released by Uncle Sam.

Financial markets and investors worldwide are already on pins and needles, what with clogged arteries, reflecting a slew of bad loans, already an increasingly fact of life in the nation's banking industry, evidenced by billions of dollars in government bailout money doled out to a number of banking giants and another 29 bank failures so far this year.

Seeing is believing, they say, but what you see is not necessarily what you should believe when it comes to these stress tests. The reason: even before their release, some critics are raising serious questions about the legitimacy of the tests.

One such critic, veteran investment adviser Martin Weiss of Weiss Research in Jupiter, Fla., sees "serious problems" with their design, leading him to conclude even before the results are announced that "they're not a true test we're looking at, but a bogus test."

How does he figure that? For starters, Weiss, whose firm has done prior analyses of banks and savings and loans to determine their viability, contends the Government's tests are far, far milder than they should be. For example, he notes the government is using consensus economic forecasts in its assumptions, such as 8.9% unemployment this year and 10.3% in 2010. A true test, he argues, should assume a jobless rate closer to the peak depression level of 25%.

He also rejects the government's GDP assumptions, which call for a decline of 3.3% this year and 0.5% next year. Far more realistic, he says, would be GDP numbers closer to those recorded during the first three years of the depression, notably declines of 8.6% in 1930, 6.4% in 1931, and 13% in 1932.

"Instead of inspiring trust, these stress tests could well shatter trust," Weiss says. He figures if the government doesn't ask tougher questions, then investors surely will. The shame of it all, he points out, is there are strong banks in the U.S. that could play a constructive role in the economic recovery, but the government is diminishing confidence in the entire banking system. What ultimately will build confidence in the banking system is truth and full disclosure, but that will be woefully absent here, he says.

I recently caught up with Weiss, who was in New York City to promote his book, The Ultimate Depression Survival Guide. We had dinner at Nobu, a noisy Japanese restaurant. Luckily, none of the other diners could hear what he was saying. If they had, they might have stoned him since he is so bearish.

Since the bank stress tests are so much in the news and Weiss has been right on the money over the past few years in forecasting the advent of a skidding economic activity, major credit problems, the horror show in housing and giant bank losses, I thought a follow-up interview with our grizzly was in order to the one I conducted a few months ago.

Treasury Secretary Timothy Geithner is on record as saying most banks have adequate capital. Obviously a lot of investors believe him as they drove up bank shares about 80% from their lows during the market's 27% rally of the past couple of months.

Weiss, often referred to as Wall Street's grim reaper, strongly questions Geithner's capital assertion, noting that the latest data showed the quality of bank assets declined through the fourth quarter of 2008. Mind you, he observes, this deterioration occurred despite the government's financial injections, including those from TARP (troubled asset relief program). Further, he contends a lot of the bank stock rally is based on hype and bogus profits -- the hype being the hope that the government will make all the problems go away and the bogus profits a function of accounting shenanigans.

Based on true accounting, he believes, most big banks would have a negative net worth, which means their shares would be worth zero. How does he come up with zero? If you mark down bank assets to their true market value, it would wipe out their capital, he explains. He also believes that when the government gave Citibank $45 billion in funding last fall, it tacitly admitted that the bank was bankrupt.

Taking note of surging delinquencies and defaults on all kinds of consumer loans, including credit cards and auto loans, and the threat of mounting problems on the commercial real estate front, Weiss sees considerably more stress ahead for the banking industry. The biggest problems, he says, are in the biggest banks. At the same time, he notes, there are thousands of small community banks in much better shape.

Given his grim assessment, including his expectations of zero bank stock prices, Weiss tells me, "I would sell all bank shares like they've never been sold before." Included here are JPMorgan Chase, Citigroup, Wells Fargo, Suntrust, Goldman Sachs, Bank of America and HSBC America. He also takes a dim view of such super regional banks as Fifth Third Bancorp, Compass Banks, Sun Trust Banks and Huntington Bancshares.

Weiss contends that a depression -- which he defines as a multi-year financial and economic crisis -- is already under way. What's more, he sees no near-term closure to the problem because he says there has been no meaningful progress in dealing with the fundamental cause of the decline -- massive bad debts.

To our growling bear who is only growling louder these days, it means beware of the optimists who believe our economy is unsinkable because we have all the resources we need to keep it afloat. It also means to our grizzly a further market plunge in the not-too-distant future to around 5000 in the Dow, or about a 37.5% drop from current levels.

In short, he says, "there's going to be a day of reckoning because there's no free lunch."