Worse Than Worst Case

Nouriel Roubini argues that the bank stress tests are pointless for numerical reasons, not political ones. He reveals that the worst-case scenario being used to test banks has already been surpassed by good old reality. (emphasis mine)

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.

I wrote last week that the stress tests were useless because the results looked to be a foregone conclusion, but if Roubini is correct, we have borderline negligence and fraud on our hands here. The tests are foregone conclusions because the banks were never in any danger whatsoever of failing them. It seems to me that Roubini is suggesting that the numbers used in the stress tests were so unstressful that of course all the banks would pass -- and combined with the mark-to-market accounting changes, we're seeing borderline mass fraud being perpetrated by the Treasury department and the fiancial sector.

Ahh, but it gets worse. The unemployment rate shows every indication it will continue to increase at its current rate of about four to five tenths of a percentage point every month. We're at 8.5% now. A little quick math shows some nasty numbers ahead.

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.

Another 3 million jobs lost by the end of the year or so, plus more people joining the ranks of the underemployed and those who have simply given up. The end of the year will find some counties in America hitting 20% unemployment with even worse of a U-6 number, possibly approaching 33% -- one in three workers -- or more. That's the reality of what's going to happen over the next 12-18 months.

It really is going to be colossally bad by Q1 2010. If you haven't lost your job yet, be counting your blessings...but be aware we're nowhere near out of the woods just yet. It's very possible that we've only gone though less than half of the total job losses in this country so far from this massive recession...and if that's true, if we have another 3.5% or more to go in the unemployment rate before we bottom out, then it's going to be very very bad in this country very very quickly.

And it will be a very long time before jobs come back. They may not ever come back to some places in the country. We're literally going to need entirely new industries to get America back on its feet...but luckily, we have a President that understands that.