“It is common sense to take a method and try it. If it fails, admit it frankly and try another, but above all try something” — Franklin D. Roosevelt
Recent trends in the now eight-year-old economic “recovery” are nothing new: we’re witnessing the consequences of an endless stream of ill-conceived policies coming out of Washington that have been transforming the way Americans view their work, their retirement, and their financial future.
Despite all the ‘feel-good’ news, the fact is we are at historic extremes across the board: record levels of public and private debt, record-breaking stock prices, interest rates at or near multi-decade lows, and what appears to be the next bubble in real estate all suggest we can anticipate something other than smooth sailing ahead.
In the current environment, any rational person needs only to look at the big picture and begin taking reasonable steps to distance themselves from the risks. For those wanting to reduce their personal stress regarding the economy, may I suggest stress-testing your portfolio.
Understand What a Bank Stress Test (Really) Is
In theory, a bank “stress test” helps authorities determine whether a financial institution has adequate capital to survive under a variety of unfavorable economic scenarios. (If you want to know more about the longer definition of a stress test and the inherent minutiae, check out The U.S. Treasury’s site here.)
As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Federal Reserve conducts annual stress tests of U.S. banks to determine whether they will be able to withstand a financial crisis. The FED essentially throws a bunch of scenarios at banks to determine what will happen to their balance sheets — if, say, the stock market crashes or GDP grinds to a halt.
This all sounds good of course, but there’s a problem.
You see, these stress tests fail to take into consideration how an actual, real-world crisis unfolds, when just about every goes wrong at once.
That is precisely what happened in 2008 when Lehman Brothers went under, creating a financial maelstrom that, like dominos, almost brought down the entire financial system with it.
As a Bloomberg Editorial Board article pointed out, these tests are not credible. The Board said, “The Fed’s stress test also assumes that a thin minimum layer of equity capital — just $4 per $100 in assets — would be enough to maintain confidence in a bank’s solvency. These flaws make a passing grade almost meaningless.”
The bottom line — FED officials realize many of the major banks are in no condition to pass a painstaking test and review, so they instead play games (cheat) with the test scenario. The desired result is assured and reported as the ultimate blessing the financial system is healthy and sound. In other words, it’s not real safety, but rather a fake, smoke and mirrors kind of safety.
Know That Your Retirement Savings Will Be Affected by a Crisis
We shouldn’t kid ourselves. No matter how great Washington says the economy is, the possibility of another financial crisis is by no means far-fetched conjecture. The question is, have you thought about how a new crisis would affect your retirement savings? It is not about whether it ‘could’ or ‘might’ — it certainly will.
You might say that the FDIC covers your deposit up to $250,000 — but what if your institution is not FDIC insured or your deposit is higher than the threshold? In addition, the government promises to cover your losses in the case your financial institution fails, but who knows how long the refund process would take, say, during a real, full-blown crisis?
For that matter, how would another stock market crash impact your retirement savings — and what’s your backup plan if the market fails to rebound in a reasonable amount of time?
Your Retirement Savings Account May Not Earn Interest
It’s important for everyone to consider how interest rates will affect retirement savings, especially if rates continue to remain low for a protracted length of time. Additionally, does your plan take into account the possibility of interest rates going negative?
Again, this hypothesis is plausible. The Brits are already considering that scenario, and if you understand how quickly financial markets can move, something analogous to that could reach our shores with very little warning.
For most Americans, including retirees, their home is their most valuable asset. The world of domestic finance and global capital markets is now evolving so rapidly it no longer makes sense to continue believing your property in northern Maine or western Massachusetts is somehow ‘isolated’ from what is going on in Washington, D.C., London, or Beijing.
These days everything is inextricably connected, so you need to ask the question: Is it possible for your home to go from being an asset today to a liability tomorrow if we were to experience another real estate crash?
Takeaway
Today, the manner in which bank stress-tests are conducted makes the results meaningless, even laughable, but that doesn’t mean the concept isn’t valid. On the contrary, an honest, objective stress test is a valuable tool that can help reveal deficiencies and other problems long before they impact your bottom line. The good news is anyone can do it.
We live in an uncertain economic environment — where asset values are rarely guaranteed to stay steady, including the value of your retirement accounts. For this reason and others, I believe most Americans really want to understand the truth about their own situation.
My advice: Set aside some time to run an honest, no holds barred stress-test scenario of your own, being mindful not to underestimate the innumerable risks to your retirement security. Be careful not to make too many assumptions, and don’t be afraid to play out a worst-case scenario.
That’s the only way to really understand how good (or bad) your current retirement plan is.
