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JPMorgan's Trading Loss Is Not a Failure of the Fed's Stress Test

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JPMorgan passed the Federal Reserve's stress test in March before its $2 billion CDS loss was announced, which has many mistakenly connecting the two events.

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MINYANVILLE ORIGINAL Less than two months after JPMorgan (JPM) passed the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR), aka the stress test for banks, it announced a surprise loss of $2 billion tied to credit default swaps (CDSs).

This had many in the industry joking that "stress tests are the new ratings agencies," referring to the ratings agencies like Moody's and Standard & Poor's, which gave triple-A ratings to mortgage-backed securities (MBSs) held by banks and insured by CDSs. The analogy was partly accurate.

Both the ratings agencies and the Federal Reserve were given privileged information not available outside the companies in order to come up with their determinations. Getting a triple-A rating in 2003-2007 and passing the CCAR in 2012 were both milestones designed to give investors confidence.

It is at this juncture that the analogy breaks down.

In the case of the MBSs insured by CDSs, multiple ratings agencies were evaluating all manner of iterations of the esoteric financial instruments. Metaphorically, they were saying that, using a variety of changing criteria, they had examined untold numbers of break lines, seat belts, air bags, and crumple zones in dozens and dozens of different types of cars, and that all combinations would work. Evaluation metrics were neither uniform nor publicly disclosed as each ratings agency used proprietary methods.

It would be years before the mortgage "car" crashed. And it was discovered too late that very few of the safety devices that got a triple-A rating worked. If you consider that the average CDS from that era ended up paying $0.15 on the dollar, you could say they were 15%, not 100% effective.

Meanwhile, the CCAR was designed to evaluate the capital planning processes and capital adequacy of the largest bank holding companies to determine how the firms would fare in times of severe economic and financial stress. Specifically it was designed to show that if the banks distributed a higher amount of capital to their shareholders, they would still be able to maintain their capital levels above mandatory levels, on par with those recommended by the Dodd-Frank financial reform bill.

A single entity, in this case the Federal Reserve, did the evaluation on a standard set of criteria assuming a "what if" scenario, which included a peak unemployment rate of 13%, a 50% drop in equity prices, and a 21% decline in housing prices. The CCAR stress test results were publicly released and investors were able to see how the largest financial institutions fared on each metric. It was a transparent process and it clearly showed that 15 of the 19 banks could maintain capital ratios above all four of the regulatory minimum levels under the hypothetical stress scenario, even after considering the proposed capital actions, such as dividend increases or share buybacks. Of the passing banks, JPMorgan was neither at the top nor at the bottom of the list.

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