What if it happened again?
That's basically the question the Federal Reserve has asked the nation's 19 biggest banks, by forcing them to undergo "stress tests" to gauge what would happen in a crisis. This has become a regular aspect of the Fed's bank regulation, meant to forestall another fiasco like the 2008 financial meltdown. Back then, big banks like Bear Stearns, Lehman Brothers, Merrill Lynch, Citigroup, and Bank of America turned out to be way more vulnerable to a shock than anybody imagined, leading to massive bailouts that deeply tarnished the whole banking sector.
These days, the banks are in better shape. The Fed found that 15 of the top 19 financial institutions would have enough money on hand in a deep crisis to remain solvent and keep lending. The other four--Citibank, Ally, SunTrust, and MetLife--fell short of the Fed's requirements, but can probably meet them in the future by adjusting their business plans.
Overall, such stress tests enhance confidence in the banks, since analysts deem the tests sufficiently tough and banks would be unlikely to disclose such vulnerabilities on their own. Getting a clean bill of health from the Fed even tends to boost the banks' stock prices and allow some of them to pay or raise dividends on their stock, making them more appealing to investors.
There's no such test for consumers, of course. But maybe there should be. The deep downturn in 2008 and 2009 revealed that many Americans were living far beyond their means, with homes they couldn't afford and record levels of debt. Savings had fallen far below historic norms, leaving many without a meaningful rainy-day fund. We're still dealing with the consequences: tons of foreclosures, loan defaults, and personal bankruptcies that are still holding back the overall economy.
So if you'd like to stress-test your own finances, here are some of the key parameters the Fed is forcing the banks to prepare for:
Plunging GDP. The Fed's tests require the banks to simulate their financial situation given a deep deterioration in the economy, starting with four quarters of negative growth. That's similar to the contraction that occurred in 2008 and 2009. The Fed doesn't spell this out, but if there were a true double-dip of this magnitude, Washington's skyrocketing debt would make it far harder for Congress to pass stimulus spending, extended unemployment insurance, tax relief, and many other measures that kept the last recession from being worse.
The Fed emphasizes throughout its stress-test report that such a dire scenario isn't a forecast, but merely a hypothetical exercise. (The Fed's actual economic forecasts call for modest growth, with an outlook that's slightly improving.) But the depth of the problems that the Fed told the banks to prepare for indicates how much worse the second half of a double-dip recession might be.
Skyrocketing unemployment. In the Fed's scenario, the unemployment rate peaks at 13.1 percent and stays above 10 percent for more than three years. That's significantly worse than the last recession, in which unemployment peaked at 10 percent and stayed there for just one month. If unemployment were to hit 13.1 percent today, that would mean close to 20 million people out of work, rather than the 13 million who are now looking for jobs.
That would lead to far more bloodletting at big companies that have already cut to the bone, and the failure of thousands of additional small businesses. Job cuts would decimate sectors familiar with pain—such as construction and manufacturing—while also hitting areas that have been fairly well-protected up till now, such as technology. Pay cuts would probably become common, with raises scarce. Hardly anybody would feel their job is safe.
Deflation. The Fed wants to know how the economy would fare with four quarters of modest declines in the consumer-price index, which is far more pernicious than it sounds. When prices fall, consumers put off many purchases indefinitely, because they don't want to buy today if the price will be lower tomorrow (with Apple products being a notable rare exception). That further harms businesses that are already hurting, and makes layoffs worse. Deflation also makes debt such as mortgages and credit-card balances more expensive over time, since money earned in the future has less real value relative to debt taken out in the past. That upends the entire calculus of borrowing and gunks up the usual gears that drive the economy.
We came close to deflation during the last recession, but that turned out to be one problem we didn't have to deal with. If we did, many things would probably be much worse today.
A far deeper housing bust. Home prices have already fallen by more than 30 percent since they peaked in 2006. In the Fed's scenario, they fall another 21 percent from where they are now, for a total peak-to-trough decline of 46 percent. That would mean several more trillion dollars of lost household wealth and consumers even more depressed than they were at the lowest moments of the last recession. Foreclosures would surge again to new records, and homelessness among formerly working people could become a major national problem.
New lows in the stock market. The Dow Jones Industrial Average falls to 5,668 in Operation Gloom and Doom, which is 13 percent lower than the market bottom in 2009. That would further wreck retirement portfolios and household wealth, while scaring all but the most stalwart investors away from the market.
Nowhere to hide. Another deep U.S. recession would bring much of the world down with it. In the Fed's stress test, Europe endures a recession nearly as bad as America's, and growth in developing nations such as China and India is cut in half. If that were to happen, investors would struggle to earn a positive return anywhere, and probably park much of their money in cash accounts or treasury securities, constricting the lifeblood of a free-market economy.
All of this probably won't happen, needless to say. And many people living on limited cash flow, with minimal savings, couldn't prepare for such grim developments even if they knew they were coming. Still, disaster planning is something most Americans could get better at. As we ought to have learned, every now and then the unthinkable actually occurs.
Rick Newman is the author of Rebounders: How Winners Pivot From Setback to Success, to be published in May. Follow him on Twitter: @rickjnewman