Regular readers know I have been consistently critical of the Office for Financial Research.  Today, courtesy of Pam and Russ Martens, it was pointed out OFR is like the blind squirrel who finds the occasional acorn.    What did OFR find?  The failure of stress tests to deal with the black hole surrounding derivatives means the tests are worthless.

One of the Fed’s enhanced regulatory powers was to conduct stress tests of the big banks – effectively to convince the American people that the banks were safe and sound again. But in 2016 when researchers at the Office of Financial Research looked at how the Fed was conducting these stress tests, they concluded that the Fed was doing it all wrong. (We think this wasn’t a bug but a feature of how the Fed was pretending to oversee the Wall Street banks while allowing the dangerous derivative markets to continue.)

The OFR researchers who conducted the study, Jill Cetina, Mark Paddrik, and Sriram Rajan, determined that the Fed’s stress tests are measuring counterparty risk for the trillions of dollars in derivatives held by the largest banks on a bank by bank basis. The real problem, according to the researchers, is the contagion that could spread rapidly if one big bank’s counterparty was also a key counterparty to other systemically important Wall Street banks.

Of course, OFR managed to miss the even bigger problem.

The black hole surrounding derivatives is just as dark today as it was in 2008 – and just as dangerous. The Financial Crisis Inquiry Commission had this to say about the crash: “the existence of millions of derivatives contracts of all types between systemically important financial institutions—unseen and unknown in this unregulated market—added to uncertainty and escalated panic, helping to precipitate government assistance to those institutions.” There is not one Federal or state regulator today who could tell you which counterparty has the most concentrated risk to derivatives. Nor is there one Wall Street bank who has clarity on this issue — because the majority of the over-the-counter derivative contracts are secret contracts between one party and another.