Stress Tests: A Rose By Any Other Name

The perhaps unfortunately named “stress test” sensitivity analysis are nothing new to the financial markets. By its simplest definition, such statistical analysis has long been relied upon in fixed income markets to price debt securities and analyze credit quality.

As recently as a decade ago, before the Internet bubble burst and the market crashed, a major Street debate was that mark-to-model was a more effective method of pricing debt securities than mark-to-market.

Mark-to-model is comparable to stress-testing all types of fixed income securities based on assumed statistical ranges of values for such variables as interest rates, credit spreads, default rates, prepayment rates, etc. As time goes on, markets have more accurate data ranges to use in analyzing current debt obligations.

It is clear that realized data occasionally falls outside assumed acceptable ranges of risk. In such extreme cases, as we’re experiencing, model pricing will disappoint, as will market pricing.

US Federal Reserve Banks have also always been actively involved in analyzing banks in this manner, although not in as publicly publicized as they do today.

While the apparently obscenely extravagant bonuses paid out by American International Group (NYSE:AIG) greatly offended many investors — and that is admittedly an understatement — it should give comfort to at least some investors that AIG, Lehman Brothers, Citigroup (NYSE:C), Bank of America (NYSE:BAC), Freddie Mac (NYSE:FRE) and most, if not all, banks had similar models in place to analyze debt purchases before transacting. While traders at such firms may or may not be gifted Vegas gamblers, they are also adept at probability analysis.

Ultimately, when history of this recession is written, the media over-reaction and premature public perception of Wall Street will be revealed for what really happened…and Wall Street will be exonerated.

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