Memo to the President: Replace stress tests with viability plans

19 financial institutions (FIs) are undergoing so-called "stress tests" to determine whether they need to raise more capital. As I posted, these 19 institutions hold $608 billion in toxic waste, formally known as Level 3 assets. Now there is major drama in Washington about whether to release the stress test results on May 4th. Let me settle this one for you -- cancel the stress tests now and require TARP recipients to produce viability plans.

There are two reasons to cancel the stress tests:

  • Stress tests are flawed. How so? First, the scenarios are overly optimistic. For example, under the tests' "more adverse" scenario, the unemployment rate is seen rising to 10.3% in 2010. When Treasury picked that number the actual unemployment rate was 7.6% -- it's since risen to 8.5%. More importantly, the basic idea of the Treasury forecasting the capital needs of these 19 FIs is deeply flawed -- that's because there is no way that the Treasury can know enough about each of them to use a few economic statistics to predict how much capital they'll each need.

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