We’ve been concerned that the government’s stress test for banks won’t be stressful enough — that its employment, GDP and home price assumptions are not in line with the grim reality. But there’s another problem. Simply knowing GDP, home values and unemployment isn’t the same as knowing asset values. Eric Falkenstein rips it apart:
Banks do not have an asset labelled GDP, Unemployment, or Homes. They merely have assets with various uncertain correlations to these factors. Some correlations are truly causations, as in mortgages and home prices, but even there, the connection between one and the other is very complicated, depending a multitude of characteristics in addition to these assumptions (vintage of the loan, its Loan-to-value, the credit score, income and wealth of the borrower). In other cases, such as looking at loans to shipbuilders, the connection is far removed.
If you think finding correlations between asset prices and basic assumptions is easy, consider that Peter Schiff, someone pounding the table that home prices were overvalued because of reckless underwriting standards. His portfolios actually performed horribly last year, because he assumed that this assumption implied a weaker dollar and the US equity market would underperform. You can be totally right on assumptions, but the complexity of the economy renders that insight irrelevant.
Bingo on Schiff. Or just consider what happened when the banks first started freezing up. At that point, the GDP still seemed to be growing, and default rates weren’t expected to get all that high, but the prices completely collapsed. So it’s doubtful that we’ll learn much except that the most politically adept and connected bankers will find ways to hang around.