Farrell: Stress Test - It's Subtle, But I Hope Real

The Government put out its stress test guidelines yesterday and the market seemed to like the details.

The KBW bank index was down as much as 7.5% on the day and finished up 2.5% after the release of the stress test details. The clarity offered as to the terms of the test was better than guessing what might be. And, the economic assumptions appeared reasonable to most. The stress will include testing for a rise in the average unemployment in 2009 to 8.9% and to 10.3% in 2010. Post WW II unemployment peaked at 10.8% in November of 1980. I would guess an average of 10.3% for next year would include some months above the prior peak. The test also will assume a continued steep decline in housing prices of another 25%.

If the government deems more capital is necessary to stand up to the challenge those metrics pose, the bank in question has six months to raise it privately.

Here is where the subtle interpretation comes in.

The only place banks could raise private money (my opinion) is in the preferred market. Common equity wouldn't sell and would be far too dilutive anyway. Existing issues of bank preferred stocks have declined sharply in price as the fear is pervasive that preferreds will be thrown under the bus if semi-nationalization occurs like the FNM and FRE preferreds were when those fiascos occurred.

The government doesn't want to own the banks. There is likely to be an announcement before too long that the government will own three different AIG businesses as that company has been unable to sell assets. The thought of a very stretched Federal bureaucracy running private businesses must be scaring some people in government. Avoiding more involvement in bank affairs has to be a priority.

Also, Senator Dodd backed off his spur of the moment remark about bank nationalization perhaps being necessary. He said "My statement should have been better thought out at the time..I didn't realize it was going to have the reaction it did. I think banks run by private hands are far more desirable." Good for Chris (now my new best friend) to come out and say that.

Ben Bernanke said in response to questions during Congressional testimony yesterday that mark-to-market accounting "for assets that aren't actively traded" is very difficult to use and difficult to execute. He added, had the short sale uptick rule been in effect "it might have had some benefit" and the SEC is looking at the issue.

I might be grasping at straws in a difficult market but I see a change in the wind. The boys seem much more on the same page. If there were to be some sort of official statement on mark to market, on the uptick rule, or especially on the sanctity of private preferred stock issuance, I think the tone of the market would change. I heard one commentator say yesterday this is a market where you are either short or temporarily covering your shorts. A change from Washington could alter the perception of the viability of the financial sector and lead to a resurgence in those stocks, and the market in general.

It was a big mistake to allow Lehman to go under. It was also a big mistake to wipe out the preferred stocks of FNM and FRE. Since the government wound up on the financial hook for those mistakes it would be far cheaper and more beneficial to say that private preferreds would be held sacred and let the private market raise the money.