Stress tests could be a turning point

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Stress tests could be a turning point


By JAY BRYAN, The GazetteApril 25, 2009
  
As finance ministers from the G7 club of the world's rich economies met in Washington yesterday, their modest optimism was tinctured with a distinct undercurrent of worry.

The problem is that even with a number of indications that the worst of the global recession could be behind us, there's still one big hurdle to be jumped over: the sick U.S. banking industry.

Although the devastated U.S. housing sector shows hints of beginning to bottom out and signs of optimism have dominated financial markets recently, any new disclosure of still-hidden toxic assets on the books of U.S. banks could still crush the fragile signs of impending recovery.

That's why a key focus of attention in the coming week will be the so-called "stress tests" being imposed on 19 of the biggest U.S. banks. The tests are a government effort to evaluate any hidden weaknesses on their books that could implode if the economic slump continues much longer. The idea is that any banks with problems would be helped to raise capital right now, fixing this problem, but probably squeezing the value of their shares.

The banks themselves received preliminary results from the stress tests yesterday.

However, they're not allowed to make this information public for any individual bank until the government does so officially on May 4. The Federal Reserve did say that, in general, most banks have capital "well in excess of the amounts required to be well-capitalized." That's nice, and it seemed to reassure stock markets, but it's not really enough. The stress tests must themselves be tested once the final, detailed results are released, since there remains suspicion that they've been graded on a forgiving curve designed as much to calm financial markets as to force hidden problems into the open.

All this was the backdrop for the G7 meetings, which began with an economic forecast that sounded fairly upbeat, predicting that an economic upturn, albeit a weak one, would begin to take hold in the coming months.

But the finance ministers also hinted at the potential for very bad news out of the crippled financial system.

Canada's Jim Flaherty called repair of the financial system "the No. 1 issue," and Alistair Darling of Britain warned: "If we do not fix the banks, we will not fix the economy." The intense new focus on the underlying health of U.S. banks, whose recent earnings reports have generally beaten expectations and helped to sustain a strong stock-market uptrend, creates the possibility that the coming week could mark a turning point.

With markets in both the U.S. and Canada having powered ahead for weeks, Toronto stocks are at their highest point this year and U.S. issues not far behind, but there's still plenty of fear among investors.

This suggests that reaction to the stress tests - at least if the detailed results show them worthy of being taken seriously - could prove to be a turning point.

In that case, "either the equity rally builds on itself, or we now sink back and test the lows again," suggested Douglas Porter, deputy chief economist at BMO Nesbitt Burns.

The reason: no economy can stage much of a rebound without the fuel provided by bank credit. So if the banks really aren't quite as healthy as they've portrayed themselves, then the recent green shoots of economic recovery could fall victim to a late frost.