I have not written much about anything here at the 'Chart lately because I continue to work on my upcoming novel, due out this summer. However, I do check the news each day and have a passing awareness of the so-called “stress tests” the Fed used on the nation's big banks this past month.

A very skeptical side of me doubted that these tests would emulate much stress, but I didn't have the time to check it in detail. Today, however, I came across a report from the Federal Reserve which describes the methodology they used in their evaluations. I didn't even have to read past page 3 to realize that the stress tests completely understate the known risks faced by the banking industry.

After the title page and the table of contents, page 3 actually marks the first full page of the report entitled, “The Supervisory Capital Assessment Program: Design and Implementation.” The second paragraph of the report begins with the following sentence:

“The SCAP is a forward-looking exercise designed to estimate losses, revenues, and reserve needs for BHCs in 2009 and 2010 under two macroeconomic scenarios, including one that is more adverse than expected.”

The stress test only looks at banks through 2010? Ridiculous! The upswing in mortgage defaults expected to begin over the next few months won't even reach their peak until 2011, a full year after the period in question!

As described in this 60 Minutes report broadcast in December 2008, correspondent Scott Pelley asked investment fund manager Whitney Tilson, “How big is the potential damage from the Alt As compared to what we just saw in the sub-primes?”

Tilson responded, “”Well, the sub-prime is, was approaching $1 trillion, the Alt-A is about $1 trillion. And then you have option ARMs on top of that. That's probably another $500 billion to $600 billion on top of that.” Take a look at this graph compiled by TheTruthAboutMortgage.com in October 2007, in which they charted Credit Suisse's data regarding the likely timeframe for mortgage defaults. It show the relative “valley” of low foreclosure activity we find ourselves in right now in 2009. It also shows that the next peak in mortgage defaults should arrive in 2011.

Significant numbers of mortgage failures will certainly take place in 2010, but the Fed's “stress test” completely ignores 2011 simply because they refuse to look that far in advance! This raises the question: why does the Fed fail to look that far in advance? After all, the Fed's awareness of these numbers cannot be disputed given how widely this information has circulated around the Internet since 2007. I can only conclude that the Fed prefers not to include those numbers because to do so would make it nearly impossible to project the idea that the big banks can survive the crisis. Only by limiting their poorly-named “stress test” to a shorter time-frame can they declare the big banks to be on the mend.

We also must bear in mind the fact that the numbers compiled in 2007 only represented known problems with mortgages up to that time. They did not take into account the possibility (likelihood, really) that lower risk mortgages might also run into problems as the real estate market continues to collapse. As real estate prices continue to plummet, we must eventually reach the point where more and more homes with “solid” mortgages end up “under water,” thereby increasing the likelihood that the financial crisis could continue beyond 2011.