Could the “Stress Test” be a Big Trap?

Beginning Monday and perhaps lasting for a week, savers and investors will look forward to the publication of the results of a series of stress tests on the 19 largest domestic financial institutions as to their safety and soundness of their capital. While I do not know the details of the measurement of these tests, the absolute reliance on them seems to me like a dance at the “Mad Hatter’s Tea Party.” In my book MONEYWISE, I identify one of the causes of risk of loss of permanent capital is unanticipated events. These warnings were written in 2007 before both the recognition of the sub-prime mortgage collapse and the recognition of various Ponzi schemes, most of all Bernie Madoff’s. In these cases there were numbers trending in the expected direction and the future was expected to follow predicted patterns.

I hope that I am wrong about the statistical stress tests being applied by the government and that in the near term future, all of the financial institutions tested with their present or augmented capital prove to be safe and sound. As humans, as well as many animals, are conscious (or more likely unconscious) odds makers, the odds on the outcome of the tests are somewhat less than completely perfect.

The intent of the tests is to supposedly give us comfort in continuing to leave our capital with these institutions and perhaps more importantly be willing to advance additional capital in the form of deposits, loans, various forms of equity, and counter-party risk assumptions. This exercise is similar to, but not identical, with an acquisition study. In one way or another I have participated on both sides of the acquisition mating dance. Only at the first level of these discussions are the various numbers significant. Additional scenarios are often produced as variants of the original data. These are similar to the stress tests we are all awaiting. However, in an acquisition exercise there are many other analyses performed. Perhaps the single most important analysis is to evaluate management, to determine how much of the past was created by the leadership rather than the environment, and what is management’s expected roles in the future. The 19 financial institutions are all in competitive businesses among themselves as well as other domestic and global competitors. As an odds-maker, I put the probability of significant changes of price and other terms of trade as almost a certainty. (Unless the government will attempt to put into place monopolistic pricing discipline, under some other name, to protect its investment in these financial institutions.) There are many other elements to a good acquisition analysis. There remains one more critical screen and that is trust.

Both financial and intellectual frauds often start as business in the late stages of expansion to make up for earlier, smaller losses. The frauds are expected to be short lived by the perpetrators until assets are returned in full with interest, or when various market share or sales targets are met. Most frauds are begun by previously honest individuals or organizations. I am not suggesting any of the 19 institutions are doing anything fraudulent. However, I wonder if the stress test is leaving enough of a cushion to keep each of the 19 in a safe and sound condition if there has been undiscovered fraud committed by employees or customers/counter-parties. The odds of such occurrences are favorable; the frauds have not been discovered yet, and the people committing the fraud in some aspects may have superior data systems knowledge and capabilities than each of the 19.

The bottom line as a manager of a financial services fund: I look forward to the coming week and the enthusiasm generated by the expected results. However, I am willing to bet a year to three years from now that we will discover that the stress test failed to identify the specific stress that one or more of the financial institutions will go through. For the others that are addicted to investing in stocks and bonds of financial service companies, they may wish to widen their selections and include both large and smaller companies.

Let the games begin this week.