In July 2007, the US Federal Reserve warned that "credit concerns were spreading" and estimated that total bank losses due to US sub-prime loans could reach $100bn. Yet now, after the conclusion of its "stress tests", the Fed says total bank losses could reach $600bn.
In most companies, a 6-fold change in a key financial assumption would prompt concern that the underlying issue was not being properly addressed. But this has not happened at the Fed, which says its new tests have still focused on residential lending (including sub-prime). The potential impact of a serious economic downturn has been ignored. Only minor losses have been assumed from corporate lending.
This omission also means that the Fed is able to forecast a very sharp recovery in bank earnings of $415bn over the next 2 years. It is therefore able to reduce the banks' requirement for extra capital to $75bn. Without this heroic assumption, many of the banks would already be insolvent, as they would have to raise $185bn - a clearly impossible figure.
How does the Fed expect this wonderful recovery to occur? Conveniently, it assumes that the banks will be able to charge higher interest margins on their loans to corporate and personal borrowers. But in the blog's view, this policy is simply a short-term 'fix', and will make the overall economy worse, not better.
US unemployment, according to Friday's figures, is already at 8.9% - the peak rate in the 1974/5 downturn. And private sector payrolls are now falling at an annual rate of 4.7%, worse than at any time since 1958. This is therefore exactly the wrong time for banks to be charging higher margins on their loans. Bankruptcies will increase as a result.
The Fed's focus is still on the needs of the financial economy, as defined by Wall Street. It is ignoring the developing problems in the wider 'real economy' on Main Street, where chemical companies (and many others) are battling with lower volumes and margins.
This makes it likely that, before too long, the Fed will be back to announce even higher estimates for loan losses, as the banks are forced to make further write-offs, this time in respect of corporate bankruptcies.