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Bank Stress Tests are Cruel, But Fair: Street Whispers (Update 1)

For the next round of stress tests, the Fed requires bank holding companies to show that they can maintain a "Tier 1 common ratio of 5 percent on a pro forma basis under expected and stressful conditions throughout the planning horizon," which includes a far less severe Adverse Scenario than the previous round of stress tests, but also includes a new "Severely Adverse Scenario."

Adverse Scenario

The 2013 adverse scenario "features a moderate recession in the United States that begins in the fourth quarter of 2012 and lasts until early 2014; during this period, the level of real GDP declines 2 percent, and the unemployment rate rises to 9¾ percent." The adverse scenario also includes CPI inflation rising to 4% and equity prices dropping by 25% through the middle of 2013, with home prices declining "more than 6 percent during 2013, and commercial real estate prices [falling] 4½ percent during 2013."

Also under the new Adverse Scenario, short-term rates rise from their current range of between zero and 0.25% in order to combat inflation, reaching 2.5% by the end of 2013, while "the yield on the long-term Treasury note increases by less but still rises above 3½ percent by the end of next year; thus, the yield curve is both higher and flatter in 2013."

Adding further to the misery under the Adverse Scenario, mortgage rates rise, while "corporate borrowing rates also move significantly higher, to more than 7 percent by the end of 2013, despite only a modest increase in spreads."

Severely Adverse Scenario

The Fed's new severely adverse scenario is similar to the 2012 adverse scenario, but nastier in some ways. "In the United States, the severely adverse scenario features a severe recession, with the unemployment rate increasing 4 percentage points from current levels (an amount similar to that in severe contractions over the past half-century). Notably, the unemployment rate remains above any level experienced over the last 70 years from the middle of 2013 to the end of the scenario."

The Federal Reserve also said that under the severely adverse scenario, domestic real GDP declines by almost 5% between the third quarter of 2012 and the end of 2013, with inflation slowing to 1%. Equity prices fall by over 50%, while housing prices and commercial real estate prices plunge by more than 20% by the end of 2014.
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