Early last month the Treasury released results of the famous stress tests of the 19 largest US banks. This – more than anything else – likely is responsible for contributing to the huge bear market rally we’ve seen. If there is such thing as financial opera, this is it. The conductor – Treasury Secretary Timothy Geithner – did a masterful job at orchestrating this show.

Not long after the stress tests were announced, information was leaked indicating 2 of the 19 banks would need to raise additional capital to afford the pending damage (write downs) to their balance sheet. Then we were told a few more may be suspect. The day prior to the official announcement it was leaked that fully 10 of the 19 needed to raise more money. They all passed mind you, but more than half needed to raise money.

By now, you are already well familiar (being Triangle Wealth Management clients after all) with the fact that the stress tests involved an analysis involving 2 scenarios: 1 – a reflection of the current economic environment, and 2 – a worst case scenario. For completeness, we note that some of the assumptions in the worst case scenario are likely to be proven too optimistic – most notably the unemployment rate peaking at an average of 10.3% in 2010. Unemployment is very likely going to be in the 10.8 – 11% range in January 2010 and reach close to 11.5% by the end of the year. Thus, the overly optimistic worst case scenario means our chances of seeing further banking system stress and market volatility later this year or early in 2010 are considerable. Only when it happens the second time, it will be much harder to keep the markets (& public) calm.

In addition, the minimum capital requirements for banks was a joke. In modern/recent US history, banks held core capital in the 6-8% range (see side chart – with thanks to The Economist). This stress test permitted banks to merely have “core capital at 4% of risk-weighted assets”. Worse still, it permitted core capital to be a mere 2.7% of overall assets. This is a subtle distinction that probably does not warrant getting into.  To understand how silly this capital ratio is, imagine if the equity in your house was similarly proportioned. If your house was worth $500K, you would merely need $13.5K for the bank to be OK with the mortgage.  Have you shopped for a mortgage lately? Good thing the banks are not held to the same equity standard that they hold their clients to.

To celebrate their new found strength, Bank of America, Morgan Stanley & JP Morgan issued bonds shortly after the stress test results were announced. I’m not sure what they thought in terms of interest rates they would secure, but they ended up having to issue bonds with 3-5% interest rate premiums over similar dated treasuries. This tells us bond purchasers are more savvy than stock purchasers. Bond purchasers are demanding higher rates of return in exchange for the risk.

Cynics point out there is a coincidence the amount of money required to make the banks a safe bet is slightly less than the amount of money left in the TARP. Indeed, the people most skeptical about the stress tests are the individuals that worked on the S&L crisis in the 1980s. A previous White House economist calls the stress tests a sham.

In short, the Treasury made it as easy as possible to make sure all the large 19 banks would pass – and then more than half of them failed. This is a recipe for continued systemic risk and market volatility. If Saturday Night Live can figure out that the stress tests were a farce, they surely were.