Remember the "Feather Tests"
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Last year, as the Panic of 2008 was winding down in the spring of 2009, many people argued that there was one last hurdle for the markets.  "Stress Tests" of all 19 banks with over $100 billion of assets.  Short-sellers, doomsayers and many economists called the tests "feather tests."  They said that the tests meant nothing and that banks were in deep trouble.

Today, Federal Reserve Chairman Ben Bernanke spoke in Chicago to a banking conference about those Stress Tests, officially known as the Supervisory Capital Assessment Program (SCAP). 

Bernanke said, "The stress assessment was designed both to ensure that banks would have enough capital in the face of potentially large losses and to reduce the uncertainty about potential losses and earnings prospects....it is encouraging that, through the end of last year, the revenues of the SCAP banks have collectively reached about 60 percent of the two-year estimates under the more adverse scenario while loan losses are at only about 40 percent of estimates."

Let's restate that last sentence.  Revenues are ahead of estimates, while losses are less than estimates.  So, they weren't feather tests after all.  In fact, the "stress" that was forecasted in these tests has not come to pass. 

Nonetheless, these stress tests have taken on a life of their own. Those who never understood the impact of mark-to-market accounting in creating the crisis now cling to these stress tests.  They say that they were the final piece of the machine, assembled by the government of course, which bailed out the US economy from the evil capitalist system.  They were the piece that allowed private investment to flow back into the US banking system.

We could not disagree more.  The stress tests caused extra stress.  The biggest problem with the banking system was mark-to-market accounting.  Unfortunately, Ben Bernanke and other Washington insiders avoid discussing mark-to-market accounting altogether.  The reason is simple.  If they can avoid the accounting rule, they can claim success at fixing the banking crisis.

Look at the chart above.  Once the stress test was announced in February the market plummeted. It was not until March 9th, when investors realized that mark-to-market was really going to be altered, that the market bottomed.  On May 7th when the stress test results were announced, the S&P Financial Index had already more than doubled.  What's interesting is that actual injections of capital did not occur until after the stress tests results were announced because investors feared a government that had already proven itself vindictive and unpredictable.  It was not the results they were waiting for, but what the government might do with the results.  Once government finished those tests and stepped out of the way, and with mark-to-market accounting rules having already been changed, the dust settled and the market kept moving higher on positive earnings data and good economic news.

It was not the stress tests that turned the market around.  It was changes in mark-to-market accounting.

Source: Bloomberg, Federal Reserve 
Posted on Friday, May 7, 2010 @ 11:06 AM

These posts were prepared by First Trust Advisors L.P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.