The Fed Asks, ‘How Bad Is Bad Enough?’

The Federal Reserve is planning to stage the equivalent of a national bank disaster drill, and it is not going to be anything like the cream-puff challenges that some overseas regulators have dreamed up.

The stress test that the Fed ordered last week for the 31 largest U.S. banks includes true worst-case scenarios. Unemployment up to 13 percent, an 8 percent drop in gross domestic product, and a stock market crash of 52 percent from third quarter 2011 to fourth quarter 2012 are the stuff of economists’ nightmares. Very few believe we are soon likely to see any situations this bad, even if European measures to stabilize their credit crisis fail. The Fed itself has said that these possibilities do not represent its own outlook for the economy.

That is what a worst-case scenario is: the chance to imagine just how bad things could get, not just how bad they are likely to get. It is an opportunity to go outside the bounds of the expected and ask “what if?”

The Fed is taking the opposite route of the European banks I wrote about last week. Banco Santander and Banco Bilbao Vizcaya Argentaria announced newly optimistic assumptions about the level of risk attached to their assets in order to bolster their own numbers. The Fed’s tests will force banks to look at themselves without any rose tinting. As Karen Shaw Petrou, managing partner at Federal Financial Analytics, told Bloomberg: “The Fed’s credibility as a tough guy can’t be challenged based on this [test].”

This is as it should be. The crisis of 2008 was largely a crisis of confidence. At the time, no institution knew which other institutions it was safe to do business with, which in turn magnified the uncertainty that was the crisis’ underpinning. The Fed now seeks to provide transparency in advance, in order to slow the spread and soften the impact of any similar panic in the future. The participating banks will also be tested against a European market shock, arguably a more likely scenario than some of the others mentioned.

The Fed’s stress test is the equivalent of boarding up windows in advance of an oncoming hurricane. Even when you can see the storm coming, it’s hard to predict the exact severity. You can hope the storm misses you altogether. If it does hit, you don’t expect to get away entirely unscathed. But some basic precautions can help you to be sure your house will still be standing when the storm is over.

In this case, the Fed has its disaster drill just right.

About Larry M. Elkin 534 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

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