Extracts from the Fed white paper on “The Supervisory Capital Assessment Program” regarding the largest 19 banks in the US (hereafter, the stress test):
Losses associated with the deepening recession and financial market turmoil have substantially reduced the capital of some banks
Lower overall levels of capital — especially common equity — along with an uncertain economic environment have eroded public confidence in the amount and quality of capital held by some firms
These 19 firms collectively hold two-thirds of the assets and more than one?half of the loans in the U.S. banking system, and support a very significant portion of the credit intermediation done by the banking sector.
A snapshot of the scenarios applied, via the methodology details:
There’s also some detail on the securities holdings of the banks being stressed (emphasis FT Alphaville’s):
The majority of securities in the AFS and HTM portfolios are Treasury securities, government agency securities, sovereign debt, and high?grade municipal securities. Private?sector securities include corporate bonds, equities, asset?backed securities, commercial mortgage?backed securities (CMBS), and non?agency residential mortgage backed securities (RMBS).
About 15 percent of the portfolio is non?agency RMBS or CMBS.
Loss estimates were based on an examination of more than 100,000 securities identified by the Committee on Uniform Security Ientification [SIC]Procedures, or CUSIP. For each securitized asset, credit loss rates on underlying collateral, consistent with those loss rates used for unsecuritized accrual loan portfolios, were weighed against current credit support levels for the securities. If the current level of credit support was considered insufficient to cover projected losses, the security was written down to fair value with a corresponding “other than temporary impairment” charge, in accordance with accounting guidelines, equal to the difference between book and market value.
Special attention was paid to institutions that had greater concentrations of accumulated other comprehensive income (AOCI) relative to tangible common equity, as AOCI forms the basis of potential recognizable losses in earnings, and hence core capital, in a given period.New FASB guidance on fair value measurements and impairments was issued on April 9, 2009, after the commencement of the SCAP. For the baseline scenario supervisors considered firms’ resubmissions that incorporated the new guidance. 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.
As for accounting adjustments:
Based on information provided by the BHCs, implementation of the proposed changes to FAS 140 could result in approximately $900 billion in assets being brought onto the balance sheets of these institutions. Risk?weighted assets were increased by about $700 billion to reflect this projected xonsolidation.The on?boarding of assets also factored into our assessment of ALLL needs, and those assets were treated as new loans. A second critical set of adjustments were made to recognize the impact of discounts taken by institutions on purchased impaire loan portfolios acquired during mergers, as governed by SOP 03?03.
Several of the participating BHCs acquired loans at significant discounts as part of mergers. Based on the information provided by the BHCs, these discounts totaled more than $90 billion. These discounts were considered in assessing possible future losses for these firms under the two scenarios, since such discounts make up a large portion, and possibly all, of projected future losses on impaired acquired loans in the two scenarios. The approach used in the SCAP was to project losses on the original balances of the impaired acquired loans (that is, balances with the discounts added back to bring the impaired loan balances back to their contractual principal at the date of cquisition) and then to net these losses against the discount that the BHCs took at the time they acquired the loans
The results of the stress test will be officially released on May 4.
Related links:
Stressing out over stress tests – Portfolio.com
DIY stress test – FT Alphaville