Chris Whalen has serious questions about the Fed’s stress tests

I love Chris Whalen’s bank industry analysis. I featured his CNBC commentary yesterday. Today is his commentary from last night’s Capital Account.

The first real question: how accurate are these stress tests? In answering this question, Chris emphasises the fact that the economic environment is irrelevant. The way a stress test should be done is to analyse how the bank’s balance sheet is impacted due to adverse impacts irrespective of when or how those impacts occur. What you are trying to understand is how risky the enterprise is, how volatile its balance sheet is in order to adjust its capital base to cushion it against adverse impacts. And remember, it is the known unknowns and the unknown unknowns that are most damaging. No economic forecast can capture these.

The second part of Chris’ analysis that has to be reiterated is the mortgage exposure still on banks’ books. Right now, a lot of the mortgage exposure is being transferred from private risk to public. As I wrote last month:

Fannie and Freddie have already been nationalized and the government is already on the hook for hundreds of billions of dollars of losses as a result. Clearly, this makes it a lot easier to use the GSEs as vehicles to pump money into the economy because any incremental loss is completely obscured by the existing gargantuan losses.

–More on Banks Making Shed Loads But Fannie And Freddie “Losing Money as a Matter of Policy”

For example, Obama’s State of the Union mortgage announcement coupled with the mortgage settlement to give big banks immunity and the Fed’s aggressive monetary policy will work to help refinance loans off of bank books and onto the FHA, Fannie and Freddie’s books. The goal is to reflate the economy while transferring the risk from banks to government by allowing underwater homeowners to refinance. Now, we know that private mortgage backed securities are dead right now. In the end, all of these loans will be issued as GSE mortgages and therefore the old mortgages and associated MBS will be expunged and be replaced with new ones.

The benefit of this approach is it is a back door bailout for banks instead of a direct bailout and that makes it easier to execute. Moreover, rather than saddling government with dud loans as the Irish have done, it transforms dud loans into good ones, so that the immediate risk to the government’s balance sheet looks smaller. Only during the next recession will we understand whether the risk transfer has saddled government with unrecoverable loan assets. This is known as “extend and pretend.”

There’s a lot more here. Take a look. Video below