Details.

That was all I wanted when Treasury Secretary Tim Geithner laid out his bank recovery plan earlier this month. At the time, the bulk of his announcement was something along the lines of "We have a plan. Plans of this plan are still in planning stages. Stay tuned for more plans."

It left everyone with more questions than answers, and the market has vehemently expressed its disapproval by plunging ever since.

Details have arrived
Yesterday, the Treasury gave some color to its so-called stress test -- a way to determine if banks, particularly haggard ones like Citigroup (NYSE:C) and Bank of America (NYSE:BAC), hold enough capital to endure the grim future they're facing.

Those deemed "stressed" (aren't they all?) will have access to convertible preferred shares, yielding 9%. The securities automatically convert into common stock after seven years, but this can be done at any time. After the seven-year mark is passed, the government "... shall make reasonable efforts to sell on an annual basis an amount of common stock equal to at least 20% of the total common stock." In other words, the program should be wrapped up within the next 12 years (assuming the common shares are even worth anything at all).

Yawn
None of that was very exciting, or relevant, for that matter. What investors really wanted to know were what assumptions would be used to guide the stress test.

That's where things get interesting. The test will use a wide range of assumptions on economic growth, unemployment, and housing prices. The idea is that by using even extreme (as Treasury calls it, "more adverse") scenarios, banks can be tested for a worst-case situation.

For the three main metrics, here's the range of estimates for 2009:

Metric

Baseline

More Adverse

Real GDP Growth

(2%)

(3.3%)

Unemployment Rate

8.4%

8.9%

Housing Price Declines

(14%)

(22%)

Wait … what?
The first two metrics, GDP and unemployment, don't stick out much. GDP fell more than 3% in the fourth quarter, and even companies like Microsoft (NASDAQ:MSFT) and Pfizer (NYSE:PFE) have been laying workers off in droves. Unemployment in the high 8 percent range seems like a foregone conclusion these days.

But what hit me like a ton of bricks were the housing decline assumptions. Under the "more adverse" scenario, 2009's 22% drop in the Case-Shiller home index will be followed up by a 7% decline in 2010.

That got me thinking:

  • The Case-Shiller 10-city housing index (the one used in the Treasury estimates) has fallen 28.3% since peaking in 2006.
  • In the process, the economy was pushed to the edges of oblivion.
  • Now even government regulators -- who have a very real incentive to butter up the truth -- are forecasting another 25%-plus plunge over the next two years.
  • What effect will that have on the economy going forward?
  • [Insert favorite phrase of gloom here.]

According to Bloomberg, $3.3 trillion of home values went up in smoke during 2008, equating to an 11.6% loss. Using those same figures, a 22% drop would dissolve $5.5 trillion more in 2009. For comparison's sake, the total market capitalization of all 30 Dow Jones Industrial stocks is roughly $2.45 trillion.

Serenity now. Serenity now.

Those affected the most are obviously homeowners and banks. Nearly one out of every six homeowners is currently "underwater," meaning they owe more than their house is worth. The overwhelming majority of those underwater are still current on their monthly payments, but the more underwater you get, the larger your incentive to give up and walk away -- leaving the home to the bank.

Perhaps more importantly, as Foolish colleague Kristin Graham pointed out last fall, half a trillion dollars' worth of option adjustable-rate mortgages will reset between mid-2009 and 2012.

Plunging real estate prices can ax the prospect of refinancing once higher reset payments kick in. That, sadly (or pathetically), was strategy No. 1 for homeowners who took out mortgages they knew they could never afford. For banks with heavy exposure to exploding loans, such as Wells Fargo (NYSE:WFC) (by way of Wachovia) and JPMorgan Chase (NYSE:JPM) (by way of Washington Mutual), this is a daunting prospect, regardless of how little they paid for their respective acquisitions.

Where to now?
Add it up, and one thing seems certain: Banks with heavy exposure to real estate (which is most of them) have much, much more pain ahead. The thought that the worst is behind banks is farcically optimistic. For the broader economy, which is relying on bank stabilization before any real traction can take hold, this is yet another indication that those hanging their hats on a quick economic recovery might be unpleasantly surprised in the year ahead.

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Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase is a current and Pfizer is a former Motley Fool Income Investor recommendation. Pfizer and Microsoft are Motley Fool Inside Value picks. The Fool owns shares of Pfizer. The Motley Fool is investors writing for investors.