Ever wondered what the U.S. economy might look like should there be another Lehman Brothers-style bank collapse? Well, it would not be pretty.
Unemployment could jump to 13 percent, recalling the breadlines of the 1930s. The Dow Jones industrials might plunge 50 percent to 5,668, a level last reached before the dot.com boom in the mid-1990s. At the depths of a brutal year-long recession, output might shrink at an 8 percent annualized rate, wiping out two whole years worth of growth.
Anyone lucky enough to have a job or cash left after the carnage could snap up a home at November 2000 prices.
This dire picture is what the Federal Reserve wants U.S. banks to imagine when they test their balance sheets for resiliency against a major economic shock.
So tough is the test that Karen Petrou, managing partner of Federal Financial Analytics, quipped: "The only adverse event the Fed left out is a direct asteroid strike on a major banking center."
It sounds shocking. But it's actually similar to the firestorm that swept through the United States after the shock bankruptcy of investment bank Lehman in September 2008, which ushered in the worst recession since the 1930s.
Next time around, however, damage could be even worse because the U.S. economy would enter in a weakened state. It is still healing from the last recession and a second blow could be crippling.
Few economists predict a U.S. recession, though uncertainty is rampant. A Reuters poll earlier this month put the risk at 25 percent, down from 30 percent the prior month , and recent U.S. economic data has improved.
The Fed last year began running banks through annual "stress tests" to measure how their balance sheets and capital buffers would cope with conditions in the consensus economic outlook, plus a major shock. On Tuesday it announced details of how it will conduct its round for 2012 release.
The latest stress test is tougher than the last -- little wonder, noted Nomorua Equity Research, given Europe sliding back into recession, China slowing, financial markets in turmoil over the euro-zone sovereign debt crisis and an uncertain U.S. fiscal picture.
But Richard Bove, a banking analyst at Rochdale Securities, says it is irresponsible to put 31 U.S. banks through a worst-case scenario. A stress test this tough risks forcing banks to prepare for the worst, possibly creating what regulators fear.
"They are going to dump loans, they are going to stop lending and they are going to put us into the recession that the government wants to know how they will function within.
"This is a really stupid stress test," Bove told Reuters Insider Television.
Srinivas Thiruvadanthai, director of research at the Jerome Levy Forecasting Center, disagrees. He welcomed the Fed's move, saying it will hasten a shrinkage of bank balance sheets that is much needed to match a slower-growing economy.
The Fed stated in bold letters several times in its news release Tuesday that the adverse conditions "are not forecasts but hypothetical scenarios."
But the deep recession the Fed conjures is based upon actual experience of severe recessions, such as 1973-75, 1981-82 and 2007-2009. In fact, the numbers closely mirror the scale of damage from the Lehman bankruptcy, layered upon a weaker baseline.
The Fed also notes risks from overseas.
"An outcome like the supervisory stress scenario, while unlikely, may prevail if the U.S. economy were to experience a recession while at the same time economic activity in other major economies were also to contract significantly," it said.
If the United States were to enter a deep recession in the fourth quarter of this year, the Fed's worst-case scenario envisages the euro zone hit hard, suffering almost two year's of contraction until mid-2013, while output shrinks by a more than 6 percent annualized rate at its depths. (Additional reporting by Dave Clarke; Editing by Dan Grebler)