Sunday, March 1, 2009

The curious art of stress testing

So I’m down in Miami, lying on the beach, reading Snow White and trying to forget about New York’s brutal cold and the 90-point monthly drop in the S&P500.

I’ve always loved Miami, provided I stay exactly two days and a half. I’ll leave the details of the trip for a lighter post but, as a prelude, I strongly recommend a visit, if you’re at all interested in the true, spectacular meaning of “ponzi scheme”, “real estate bubble”, “subprime”, “jingle mail” and “foreclosures of the week”… oh, and “silicone.”

Anyway.. the topic du jour is actually Geithner’s stress tests. I wasn’t planning on touching this potato, but, while at the beach, something surreal happened… I was approached by a woman who, a few minutes into our conversation, asked me whether I was from New York and… would I like a free stress test?!!

I should say I’m far more skeptical about Geithner’s stress tests than those free ones I was offered (which I did not take). And it looks like I’m not the only one, although many of the criticisms so far have centered on what may be a “secondary” problem—namely, that the “dark” scenario is not dark enough.

[As a refresher, the stress tests are supposed to test the resilience of banks’ capital under two macroeconomic scenarios. More details here.]

Undeniably, the dark scenario reveals some lack of imagination by those who conceived it. But there are many more problems with the stress tests before we even get there.

First, unless I’m missing something, we still don’t know how Geithner & co. are planning to treat the toxic assets in banks’ books. Now that’s an omission with a Big O! Stress tests are supposed to estimate the probability distribution of an institution’s losses under a “stressed” scenario. So a “stress-tester” would need to have a starting value of a bank’s assets; and a model of how the prices of these assets will behave under the scenarios considered.

We certainly lack the former. And I wonder... Is it because the tests will only cover the banks’ loan books (and not the trading books)? Is it because the Treasury plans to sideline the toxic assets for now, under the (ambitious) assumption they will be dealt with by Geithner’s one-trillion-dollar Public-Private Investment Fund (the “PPIF”)? Or is it because they plan to use banks’ own model-driven valuations to price these assets?

Whatever it is, the whole thing smells of "obscurity" and/or “partial coverage”… neither of which is good for instilling credibility in the government’s verdict about the health of financial institutions, post stress-tests.

Secondly, stress tests on individual institutions fail to capture the systemic implications of financial distress, e.g. due to contagion or feedback effects. We've already experienced “contagion par excellence” after the collapse of Lehmans. We've also witnessed (and continue to witness) the feedback effects of financial distress: Declines in asset prices have undermined banks’ capital position, forcing them to deleverage. This has meant further asset sales and, in turn, further asset price declines and so on. Alternatively, as banks’ capital is eroded, they tighten lending standards, prompting the distress in firms that need financing—which could of course lead to further losses for banks.

The lack of a(n adequate) systemic perspective in financial supervision was arguably one of the big supervisory failures that contributed to the crisis today. And yet, Geithner’s stress tests, to my knowledge, do not try to address it.

Third, it is unclear whether the tests will assess banks’ vulnerability to liquidity risks beyond the risks to their capital position. Once again, that would be a huge omission. Banks face tremendous liquidity risks today both on their assets and their liabilities. In the case of the former, they hold a whole lot of illiquid stuff that is currently impossible to sell without major haircuts. In the case of liabilities, banks’ increasing reliance on the wholesale market for their funding, and the dysfunctions of that market ever since the credit crisis hit, have made them vulnerable to the vagaries of investor sentiment.

True, Ben and his crew at the Fed have stepped in to neutralize this risk. But if the stress tests are meant to encourage investors to lend to those institutions that “pass” them (with or without recapitalization), leaving liquidity risks aside will not do the job.

Finally, a fairly pedantic, yet inevitable point: I mentioned earlier that a “stress-tester” needs, among other things, a model that relates the macroeconomic variables of the stressed scenario (e.g. GDP growth, unemployment, house prices etc) and the variables one needs to assess banks’ potential losses—e.g. probabilities of default, interest margins or the prices of, say, mortgage-backed securities.

Well, good luck with that! Not because such models (for what they’re worth) do not exist; they do, but they necessarily rely on historic data. Yet, the macroeconomic and market dislocations we have recently experienced may have caused a change in the models’ parameters. This means that whatever loss distributions are estimated may be off the mark!

I don’t want to throw the idea of stress tests out of the window. On the contrary. Stress tests are becoming an increasingly useful tool in the financial supervision process and there is a whole body of literature trying to devise ways to make them better.

But it’s important to understand their tremendous limitations: I encourage you to (re-) read the Bank of England’s July 2006 Financial Stability Report. I must say it’s more surreal than Barthelme’s Snow White! The report identifies on a qualitative basis almost each and every extreme risk that ended up materializing about a year later.

Yet, despite its state-of-the-art stress-testing methodologies, the BoE could only go as far as to acknowledge the difficulties in quantifying many of those risks! The risks it did quantify with the help of the stress tests were just a fraction of the problems that eventually emerged last Fall. Of course, the limitations of stress-testing are even larger when the scope of the tests is fairly narrow (as per the Geithner plan).

Ultimately what investors need is clarity over the hole in banks’ books. The downside risks from a severe macroeconomic scenario are (an important) part of that assessment. But there are many other burning components—notably the toxic asset issue—which, unfortunately, remain unaddressed.

I therefore fear that the stress tests, particularly in their “Geithnerian” form, will fail to rekindle investor confidence in the health of the financial sector. Worse… they won’t be for free!


Anonymous said...

Love your blog. Thanks for writing it. I find it very helpful.

Anonymous said...

Do read Buffett’s commentary on derivatives. Here’s an excerpt

Indeed, recent events demonstrate that certain big-name CEOs (or former CEOs) at major financial institutions were simply incapable of managing a business with a huge, complex book of derivatives. Include Charlie and me in this hapless group: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.”

Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them. When I read the pages of “disclosure” in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don’t know what is going on in their portfolios (and then I reach for some aspirin).


The Bear Stearns collapse highlights the counterparty problem embedded in derivatives transactions, a time bomb I first discussed in Berkshire’s 2002 report. On April 3, 2008, Tim Geithner, then the able president of the New York Fed, explained the need for a rescue: “The sudden discovery by Bear’s derivative counterparties that important financial positions they had put in place to protect themselves from financial risk were no longer operative would have triggered substantial further dislocation in markets. This would have precipitated a rush by Bear’s counterparties to liquidate the collateral they held against those positions and to attempt to replicate those positions in already very fragile markets.” This is Fedspeak for “We stepped in to avoid a financial chain reaction of unpredictable magnitude.” In my opinion, the Fed was right to do so.

A normal stock or bond trade is completed in a few days with one party getting its cash, the other its securities. Counterparty risk therefore quickly disappears, which means credit problems can’t accumulate. This rapid settlement process is key to maintaining the integrity of markets. That, in fact, is a reason for NYSE and NASDAQ shortening the settlement period from five days to three days in 1995.

Derivatives contracts, in contrast, often go unsettled for years, or even decades, with counterparties building up huge claims against each other. “Paper” assets and liabilities – often hard to quantify – become important parts of financial statements though these items will not be validated for many years. Additionally, a frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by the billions become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other ways as well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with.