Wednesday, March 14, 2012

Stress Test Assumptions

The Fed released the results of its most recent stress test yesterday, which showed that the majority of US banks have plenty of capital to survive a hypothetical stressed economic scenario.  Below are the assumptions that were used to administer the test, which include a 50% decline in equity prices, a 20% decline in housing markets and unemployment increasing to 13%.

The assumptions made for credit spreads are a little bit curious.  BBB spreads peak at around 500bps, despite peaking at 800bps in 2008-09, and mortgage spreads also don't increase by much even though the housing market would be falling apart and Fannie and Freddie would likely be in need of another few hundred billion dollars in bailouts.

The most egregious assumption is likely the rate on the 10 year treasury though.  The most likely reason that the US would enter such a severe recession in the next 5 years is because the government has to balance the budget in a Greek-like austerity.  In that scenario treasury yields wouldn't be below 2%.

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