The Stress Tests Should be Stressful

The stock market continues to climb to levels not seen since early January, with today’s strong run-up in financial stocks largely attributed to diminishing fear over the soon-to-be-released results of the bank “stress” tests. The S&P 500 closed over 900 this afternoon with financial stocks leading the way–the financial sector ETF (XLF) finished up more than 6% today. More results of the bank stress tests have been leaked, with today’s story being that regulators will ask Wells Fargo (WFC) to raise additional capital. We may be old fashioned but when a company is told by regulators that it must shore up its capital base, this is bad news. In current market conditions, a warning by regulators to raise capital causes the warned bank’s stock to surge 18%, this on top of an already strong two-month price rebound. Today, Bank of America (BAC) is back above $10 (up more than 15%) after denying reports that it was looking to raise an addition $10 billion.

“Citigroup, Bank of America, as well as Wells Fargo may need additional capital, as Rebecca said, BofA is denying a report earlier today it would need to raise $10 billion in fresh capital. Wells Fargo, the AP reporting earlier it would be one of the banks to raise fresh capital. This is not affecting their stocks today. All of them moving higher.” CNBC’s Closing Bell 5/4/2009.

The stress test results, or what we know of them, have been pretty unflattering regarding the health of the financial companies and yet the rally in these shares continues. Why is the market seemingly overlooking the negative findings of the stress tests? One possible answer is that the recent stock rally has made investors more willing to take on greater risk. There is a necessary correlation between risk and return and it seems that the recent rally has reduced the fear levels of formerly white-knuckled investors who now appear willing to take on greater risk in order to achieve potentially better gains.

Furthermore, the Treasury is dribbling out the results in a way that enables investors to digest little bits of bad news one at a time. Last week, we heard that Bank of America and Citi would not pass the stress tests without a capital infusion. The market did not appear surprised by this news. Later in the week, we heard that no less than six of the 19 largest banks were not sufficiently capitalized to withstand further economic deterioration. The market did not seem to be bothered by this news as well. Now we hear that Wells Fargo, with its large exposure to residential mortgages, will need additional capital yet WFC rallies strongly. Now some speculate that the stress tests were really not all that stressful to begin with. The worst case economic scenarios were really not that far away from where the economy currently stands. So what is the real point of these stress tests? This does not appear to be a valid stress test the results of which might truly prove useful should the macro-economy continue to worsen and the banking system face a renewed downward spiral. We worry that the Treasury’s stress tests have been a waste of time and energy, and the nation would have been much better served to have real assessment of the survivability of the nation’s banks should the economy not improve but actually further worsen in the coming months.

The Stress Tests Should be Stressful

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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