What Does A Bank "Stress Test" Entail?

(CBS)  It's the toughest test the nation's 19 largest banks will ever take.

The stress test demands that banks imagine the worst possible economic news, a so-called "stress scenario," and then calculate if they've got the capital reserves to cover losses. CBS News correspondent Wyatt Andrews reports.

The key questions on the stress test?

What if unemployment rises to 10.3 percent? What if home prices plunge 22 percent? And what if overall economic growth drops to negative 3.3 percent?

Most important under these conditions is what will happen to the banks' balance sheets? What does the bank lose from increased defaults on mortgages, auto loans and credit cards?

The results will reveal how much more money the banks really need, probably from taxpayers, to stay solvent and keep lending.

Ed Yingling is the CEO and president of the American Bankers Association. Yingling said, "They want to see well, if things get terrible and last a long time, will we need extra capital as an insurance policy?"

What does it all mean? For taxpayers, it means another draw-down of bailout funds Congress passed last October.

What does it mean for investors?

Ironically the stress tests - even by revealing a bank's true worth - will signal to Wall Street the government's commitment to keep banks afloat.

"Hopefully what it will mean for Wall Street investors is that they will have more confidence," Yingling said.

Most important, what does this mean for lending?

Any of the 19 banks taking new bailout funds must agree to lend more than before, "to meet the credit needs of their customers, even in a stressed scenario," said Bernanke in a Capitol Hill hearing.

But there are two big things treasury officials don't know for certain.

They don't know whether, instead of instilling confidence, they might actually undermine confidence in banks that fail the test.

And they don't know if the remaining $350 billion in bailout funds will cover what the 19 banks really need.

[pensacola8-2009]

The bank stress test under existing scenarios can give banks a passing grade, but if unemployment inflates, a future stress test may yield a failing grade as bank sheets start revealing increasing capital losses.

While the new housing market seems to absorb employment losses because they are mainly comprised of self-employmed workers, the auto industry is not. The business models for the auto industry tell us that consumers need vehicles they can most afford without credit. IF the auto industry can produce vehicles with a target price under $7,000, they can survive and retain the greatest level of employment.

The debt level of all credit borrowers combined at this time is greater than the GDP of this nation.

Those employed who can accelerate their personal debt repayment and devote greater percentages of their budget to savings and investment, will make a combined effort that will help this country this nation that equals the effort of the federal stimulus and spending budget. The government can not be effective acting alone.

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STRESS TEST FOR BANKS-WHY NOT A STRESS TEST FOR BORROWERS

Treasury Secretary Geithner will perform stress tests on banks to determine their financial health. Borrowers can also be tested to determine their financial health by evaluating their personal financial blood which consists of assets, liabilities, income, and expenditures. A personal financial blood test can diagnose and identify the borrower?s financial weaknesses and prevent financial distress.

The personal financial blood test provides immediate feedback on the financial health of the borrower. This test will guide the borrower to make the monthly mortgage payment and avoid slipping down the slippery-slope towards delinquency, default, and foreclosure.

What is a personal financial blood test?

We annually monitor our personal health by going to the doctor and taking a blood test. The blood test helps the doctor predict and diagnose health problems in time for correction. In the same way that the doctor uses the annual blood test to measure personal health, the annual personal financial blood test can be used to measure changes in the borrower?s financial position to keep the borrower on-track and avoid the financial mistakes of the past.

The Obama Administration and the financial community are concerned about the troubled assets which are clogging the balance sheets of the banks and restricting the flow of credit to individuals and businesses. While these troubled assets remain on the banks' books, write-downs and losses will continue to cause economic havoc and drain the strength of the financial sector.

There is growing concern that the losses on the valuation of these assets will continue to materialize as borrowers default on their Alt-A, Option ARMs, Interest-Only, and other toxic mortgages. These toxic mortgages are the underlying assets interwoven within the Mortgage-Backed Securities, Collateralized Debt Obligations, and other complex derivative investments that are leveraged into the trillions of dollars worldwide. Since the valuation of these toxic assets depends on the borrowers' ability to make the monthly mortgage payments, the key to solving the economic crisis is to maintain the borrowers' financial health throughout the term of the mortgage.

It is expected that 8 million of these borrowers will default and suffer the loss of their homes to foreclosure over the next four years. Borrowers are in desperate need of financial guidance in this complex economic environment. The personal financial blood test will help the borrower understand how to manage money in the shortest possible time and avoid the pitfalls that have previously caused financial distress.

As the borrowers are successfully guided to make the monthly mortgage payments, the financial and housing markets will respond favorably. The result will be a reversal of the downward trend in the valuation of the troubled assets.

Samuel D. Bornstein
Professor of Accounting & Taxation
Kean University, School of Business, Union, NJ
Bornstein & Song, CPAs & Consultants
Tel: (732) 493 - 4799
Email: [e-mail]