Stress Tests

Ever since Geithner announced they would be conducting "stress tests" on the banks a few months ago, people have been speculating on the outcome and what it will mean for the markets. Some argue that the government won't publish negative results because that would spook the markets. Others hypothesize that good results will be viewed skeptically by the markets, owing to the fact we all "know" the banks are in bad shape. In recent weeks, the discussion has elevated to a near frenzy of speculation. It seems not an hour goes by that I don't read about someone making prognostications about the results, citing leaks of information and hypothetical responses. Intellectual power everywhere is frantically trying to predict the outcome. I suppose it is an exercise in game theory- if this happens, they'll do that and the market does this...

Now, we here at TLRB have no special insight into the tests (other than that they are stressful, but not that stressful). I do know that watchers the world over are probably wasting their time and effort trying to handicap the issue, for the problem has several impossibilities that make it useless to work on.

Let's examine the possible outcomes vaguely. For example, the tests could be generally viewed as negative (i.e. banks need capital). If so, does the market respond by panicking? Or does the market say "hey, they are going to provide the capital, as they said they'll do, therefore the tests have prevented another run"? Similarly, if the tests are positive, does the market shrug off the results as biased spin or does it accept them as a good sign?

In other words, the market's response is an event contingent on the outcome of the first event (test results). We don't know the test results; We don't know how they will be presented (except for very recent leaks, see todays WSJ); we don't know if the results will come along with remedies or penalties and we don't know how the market will respond to any number of combinations of possible outcomes. It probably depends on the collective mood of investors in how the results are digested. In short, I fail to see a way to confidently predict the situation's outcome. Naturally, some smart folks out there will claim they do. And some of them will be right, through skill or luck, probably more of the latter. I wouldn't bet on it though.