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What the Fed's Stress Test Means for the Housing Market

In the wake of the financial crisis that rocked the economy, Congress passed the Dodd-Frank financial reform bill. This law requires the U.S. Federal Reserve to subject the nation's largest banks to a series of tests designed to calculate their liquidity and solvency in times of economic uncertainty. According to its website, the Fed did not object to the any of the 28 banks' capital plans presented during stress testing. However, Bank of America is required to submit a new capital plan to address certain weaknesses. In its findings, the Fed discovered U.S. firms have more than doubled their capital reserves since 2009, with the common equity capital ratio growing from 5.5 percent to 12.5 percent in the fourth quarter of 2014. Overall, this represents an increase from $641 billion to $1.1 trillion in capital holdings.

The first portion of the stress test involves the Dodd-Frank Act Stress Test. The DFAST compares banks' balance sheets with one another. After comparing the numbers on paper, the Fed subjects the banks to a series of scenarios testing how these financial institutions would react to economic turmoil, surging energy prices and diminished corporate credit. The second round of its stress test is known as the Comprehensive Capital Analysis and Review. Once banks complete the CCAR, the Fed stitches the results together to form a comprehensive listing of the state of the banks. As Moody's Analytics noted, while the CCAR is limited, the rigor and transparency of the tests provide good reason to have confidence in the U.S. banking system.

How this affects the housing market
Put simply, one of the underlying problems that caused the financial crisis of 2008 had to do with banks bundling together subprime mortgages and using these to back collateralized debt obligations, which were sold off to investors. According to The Economist, when homeowners were unable to make their payments on bank notes for the houses, it set off a chain of events that made the CDOs essentially worthless. This made the debt obligations impossible to sell and they instantly cut into the banks' capital accounts. Due to mark-to-market rules, these institutions incurred significant losses since they had to acknowledge the devalued assets on paper. Combined with the complex chain of debts created by these firms, the financial sector was unable to sustain the pressure and it effectively almost collapsed the entire economy. Only by propping up with the banks with money from the Troubled Asset Relief Program did the country fend off a depression.

Banks passing stress tests

With all the banks passing the stress tests, it means they are capitalized and ready to extend loans.

Since all the banks passed this year's stress test - the fifth round since testing began in early 2009 - it is indicative of a strong banking system that is well-capitalized with better access to credit sources. After the financial crisis, many banks were hesitant to extend credit to borrowers, leading to a contraction of the housing market. However, with all the major firms passing the Fed's stress test, many economists believe banks will be much more likely to approve mortgages and extend credit to more people. 


With such a sound financial foundation, the banks are in a good position to lend money to people looking to buy homes or refinance their current mortgage. According to Reuters, many market watchers expect the Fed to raise interest rates sometime in September 2015. If this happens, there's a chance that it will drive up interest rates on mortgages as well.

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