Presenting the Fed's [LOL] Worst Case Stress Test Assumptions: Why Another TBTF Bailout is Guaranteed, If Not Imminent

As the threat of nuclear disaster in the world's third largest economy looms, the Federal Reserve saw fit today to permit some of the largest 19 US banks to erode their meager capital bases by increasing or restarting the payment of shareholder dividends, as well as ramping up stock repurchase programs.

According to Business Wire, already JPMorgan Chase has announced it will quintuple the next quarterly common stock dividend payable April 30, 2011 to $0.25 per share (from $0.05 per share), in addition to the announcement of a new $15 billion multi-year common stock repurchase plan, with $8 billion approved for 2011. Similarly Wells Fargo announced a special March 31, 2011 dividend of $0.07 per share, an increase of 29% from the $0.05 per share dividend declared on January 25, 2011.

And, as we write, Goldman Sachs has just announced it will redeem all 50,000 shares held by Warren Buffet's Berkshire Hathaway at $110,000 per share, plus accrued and upaid dividends, which includes a one-time preferred dividend of $1.64 billion. [Recall that Buffet likely had a ring side seat to the negotiations that were going on at the highest levels of the Treasury and Fed.] Nice profit on your $5 billion sure thing investment, Warren.

In support of this regulatory grant of capital erosion, the Federal Reserve Board of Governors today released its Comprehensive Capital Analysis and Review: Objectives and Overview. From the report:

I. Executive Summary The Comprehensive Capital Analysis and Review (CCAR) involved the Federal Reserve’s forward‐ looking evaluation of the internal capital planning processes of large, complex bank holding companies and their proposals to undertake capital actions in 2011, such as increasing dividend payments or repurchasing or redeeming stock. On November 17, 2010, the Federal Reserve issued guidelines to provide a common, conservative approach to ensure that these bank holding companies hold adequate capital to maintain ready access to funding, continue operations and meet their obligations to creditors and counterparties, and continue to serve as credit intermediaries, even under adverse conditions. 1 Nineteen large bank holding companies submitted comprehensive capital plans and additional supervisory information to the Federal Reserve in early January. 2 The Federal Reserve evaluated these plans across five areas of supervisory consideration. These are the bank holding company’s

1. Capital assessment and planning processes;

2. Capital distribution policy;

3. Plans to repay any government investment;

4. Ability to absorb losses under several scenarios; and

5. Plans for addressing the expected impact of Basel III and the Dodd‐Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd‐Frank Act).

The purpose of this paper is to provide an overview of the methodology that the Federal Reserve used in reviewing these five areas; a description of the CCAR’s supervisory context, including an explanation of how its results should be interpreted; an explanation of the CCAR’s connection with the Supervisory Capital Assessment Program (SCAP) and stress testing requirements mandated under the Dodd‐Frank Act; and the Federal Reserve’s expectations regarding disclosure of the CCAR’s results.

Not all of the 19 bank holding companies proposed an increase in capital distributions in connection with the CCAR. ...

Skipping ahead to the methodology of the stress testing (emphasis and brackets ours):

The supervisory stress scenario was intended to represent developments in a recession, with negative economic growth for at least a couple of quarters, a rise in unemployment, and a sharp drop in risky asset prices. The scenario covers the nine‐quarter planning horizon of the stress scenario analysis – 4Q 2010 to 4Q 2012 – and an additional four quarters through the end of 2013, to provide a basis for estimating loan losses and thus loan loss reserve needs at the end of the planning horizon. The scenario was developed in early November 2010, and is based upon the economic and financial market conditions prevailing at that time. [Note: this is prior to civil unrest in MENA and the Tokyo quake/tsunami] Table 1 reports the key variables defining the supervisory stress scenario; the full scenario is available in the appendix.

In addition to the macroeconomic scenario provided by the Federal Reserve to all 19 bank holding companies, the six largest firms were required to estimate potential losses stemming from trading activities and private equity investments using the same severe global market shock scenario that was applied in the SCAP. Specifically, the firms estimated potential mark‐to‐market and default‐ related losses on trading and private equity positions and from exposures to trading and financing transaction counterparties. The scenario provided assumed an instantaneous revaluation of these positions that was based on the change in market risk factors from the end of June 2008 to the end of December 2008. The scenario required the six firms to assume that the deterioration in global markets that occurred over this period would occur in one day. [Is this a prediction of another Flash Crash?] This represents a very ["]conservative["] scenario and by design allows for no offsetting benefits from any actions management at the firms might be able to take to mitigate losses from these exposures as the scenario unfolds.

More detail appears in the Appendix, as referenced above:

Click for large image.

With 10 Year Treasurys projected to reach a maximum of 3.81% into Q4 2013, the Fed seems to be operate under the delusion that US Treasurys will perennially benefit from flight to quality status. As Zero Hedge points out, if Japan's response to an admittedly unmitigated disaster is to print the equivalent of half a trillion Dollars in one week, how quickly will Bernanke, Trichet & Co. be to pound the printing button as contagion and fallout spreads to the rest of the world from any one of a variety of sources? Even more preposterous is the Fed's expectation that the BLS' CPI (itself a gamed statistic) will fluctuate in a narrow annualized band of 0.90% to 1.85%, thus ignoring the effects of both deflationary and inflationary shocks.

On the heals of serial eruption of violence and chaos, the very banks that are guaranteed to receive taxpayer support in the wake of future financial disaster will be in a weaker capital position because of the actions today of the Federal Reserve, whose economic worst case scenario predictions will look tamer than baby Bambi in the rear view mirror of the post-Dollar, post-QE apocalyptic financial landscape of 2014.

Full laugh cry-out-loud report may be found here.