Geithner’s Red Herring

I read a lot of Red Herrings. These are the, not quite final, versions of what will become a Prospectus. If you want to sell a security to the public you have to circulate a Red Herring and ultimately a Prospectus. It is how Wall Street works.

The Red Herring contains a great deal of the information that an investor would need to know before he wrote a check. They all look alike. There is always a section on Projections. In that section there is information that allows the reader to ‘stress test’ the deal. The information is always presented with Base, Best and Worst case assumptions.

I have Swiss blood in me so I go directly to the Worst Case and take a look. If an argument can be made that the Worst Case (a) will not happen and (b) even if it does it looks manageable, then I will take a deeper look.

Mr. Geithner has never written a Red Herring. It is interesting to look at his approach for stress testing.

On the matter of Projections there is a significant difference between the DC version and the Wall Street version. While Wall Street provides a Base/Best/Worst case Treasury provides only a Base Case and something called “More Adverse”. This is tricky Washington speak. The More Adverse standard is just an excuse to stress test the banks with something quite different than a Worst Case. This is Stress Test Lite. It looks more like a Red Alert than a Red Herring

There are three components to the More Adverse stress test, GDP, unemployment and home prices as measured by the Case-Shiller index.

These are the GDP assumptions that are being used by Treasury for the More Adverse analysis:


Let’s hope that things turn out this way. The forecast calls for a resumption of growth by the end of the year. It assumes that we will be returning to ‘Trend Line Growth” next spring.

This forecast is not out of line with a lot of well respected economists. These same economists have missed the boat on their forecast of economic activity for the last year and a half. While the Treasury More Adverse assumptions are defendable they have nothing to do with stress testing the banks on a Worst Case basis. In my view a legitimate stress test for the banks would have used a GDP forecast of flat growth for the whole year. The idea that the ‘down side’ is defined as a return to normal economic growth in just twelve months seems a tad optimistic.

The assumptions used for unemployment are for an average of 8.4% for 2009 and 10.3% for all of 2010. The unemployment rate is currently 8.1% and rising rapidly. The 8.4% assumption for unemployment will almost certainly be exceeded. Unemployment is a lagging indicator and will likely rise in 2010 even if the economy stabilizes. In the post WWII period US unemployment exceeded 10% only once. That was in 1982. During the Depression unemployment topped out at 25%. That is not going to happen again. However, in the ten year period from 1929-1939, the unemployment rate averaged 15%. The post war history of unemployment at less than 10% will be tested in the next year. We may not be having a depression, but this is the mother of all recessions.

The More Adverse case for housing prices relies on the Case-Schiller index. In this most critical area the Treasury appears to have chosen an aggressive litmus test. The assumption used is that the National Housing index will fall by less than 20% from the levels of January of 2009.

One would think that an additional drop of 22% could not be possible. However the same index has fallen by more than 30% in less than two years. We are now at 2003 levels for housing prices. If we fell to 2000 prices it would exceed Treasury’s down side benchmark. More troubling is that the Treasury analysis has the drop in home values leveling off in less than one year.

The Case–Shiller index has accurately described what is going on in the real estate market. However, the stress test should have been based on the 20 City report versus the National Average. The 20 City report is more likely to drop by 20% than the national report.

On balance, the Treasury Department did an okay job of establishing the criterion for their stress test. They very deliberately chose not to provide a set of Worst Case Results. They are only stressing the banks to a standard of More Adverse. If they had chosen a stricter set of standards for this test it just would have meant that more banks would have failed the test. There is no more TARP money to speak of so the standards must be driven by the available capital to fix the problem banks that result from the test.

On May 4th Treasury will release the results of their efforts. This is what they will say:


I would read their announcement differently. I would read it to say:


Of course you will never see that. You just might however see GDP declining for longer than anticipated. Unemployment looks like a lay up to exceed 10.5%. If those conditions are what we will be looking at, then it is not too hard to forecast an additional 20% drop in RE prices on a national basis.

The conclusion is simple. Either we get out of trouble pretty quickly or we will be in a lot of trouble before too long. Let’s hope Keynesian economics will work one more time.