Moments after the Federal Reserve released its 21-page stress test methodology white paper (official name: The Supervisory Capital Assessment Program: Design and Implementation), stock prices, which had been trending upwards all day, broke sharply down. Then, presumably, after scanning the white paper, investors either realized that there was no news, or concluded that the test requirements weren't too tough, and started bidding up prices once again, even more giddily than before.
Critics who are convinced that the stress tests are a sham are unlikely to be disabused of that notion by a close reading of the guidelines. On more than one occasion the white paper touted the "150" bank examiners who have been reviewing banking data for months with their fine-toothed combs, but I'm with Naked Capitalism's Yves Smith on this one: that seems a pathetically small number of people with which to review the books of just one major multinational goliath banking institution, much less nineteen. The authors of the white paper also acknowledged that the economy has deteriorated faster than its baseline scenario predicted, but still don't appear eager to pump up the parameters of the "more adverse scenario" in response, saying only that "the more adverse alternative is not, and is not intended to be a 'worst case' scenario. To be most useful, stress tests should reflect conditions that are severe but plausible."
One interesting point: the white paper states that the stress tests were "designed under the assumption that the institutions continue to operate under the regulatory and accounting frameworks existing as of December 31, 2008 and considering the effect of significant changes that have or are expected to occur during the next two years."
That would include the weakening of mark-to-market accounting rules recently announced by the FASB, and would, on first glance, seem to offer the banks a way to whitewash potential liabilities. But later, the white paper states that the new FASB guidance was only incorporated for the baseline scenario. "However, for the more adverse scenario, in order to reflect greater uncertainty about realizable losses in stressful conditions, supervisors did not incorporate the new FASB guidance."
Which makes sense to me. The more stressful things are, the less likely it is that accounting trickery will save the banks' bacon. But the real question still remains: Just how bad will it get?