What do the stress tests really mean?

According to the New York Times, the bank stress tests show that the banks are still solvent, and that they are in better shape than assumed.

That's great news, right?  We would all be very happy if the banks became healthy and the economic crisis ended. 

But it now appears that more than half - 10 out of 19 - of the banks subjected to stress tests will need to raise more capital.

In addition, it is no secret (as apparent from the leading financial news services) that many experts are cynical of the stress tests:

• PhD economist Nouriel Roubini said that the stress tests used scenarios more optimistic than what the economy is actually experiencing, saying:
  

  The results of the stress test – even before they are published – are not worth the paper they are written on as they make assumptions on the economy that are much more optimistic –even in the worst scenarios that the FDIC has designed - than the actual figures for Q1 of 2009.

  Roubini also wrote:
  

  Our estimates ... are even higher, at $3.6 trillion, implying that the financial system is currently near insolvency in the aggregate. With the U.S. banks and broker-dealers accounting for more than half these losses there is a huge disconnect between these estimated losses and the regulators' conclusions.

• Nobel prize winning economist Paul Krugman said that the stress tests are merely a "self-esteem class" for the banks (and see this)

• Former head economist of the International Monetary Fund Simon Johnson called the stress tests a "whitewash"

• FDIC chief Sheila Bair has said the tests are a sham

• Former senior S&L regulator William Black previously called the stress tests a sham and a hoax

• The chair of the Congressional Oversight Panel, Elizabeth Warren, is highly sceptical of the stress tests

• A scholar of risk and chance at Polytechnic Institute of New York University, Nassim Nicholas Taleb, said "This stress test is the equivalent of testing the Brooklyn Bridge by running a single heavy truck on it. Bring engineers for this stress test, not the economists who failed us."

• University of Oregon economist Mark Thoma said "the stress tests weren't tough enough" to begin with, "so I interpret this as saying that even with a fairly weak test, problems surface easily. Who knows what we might have found with a tougher test, and how much additional concern that might have caused."

• University of Texas economist James K. Galbraith said:

My sense is that the tests understate the problems because they emphasized the econometric relationships between economic conditions and assets of an assumed quality, rather than the underlying loan quality. The main procedure as I understand it was to ask the banks to simulate their own portfolios under various economic scenarios, meaning that the banks' own view of loan quality was largely accepted. Loan quality is the big problem, because if the sub-prime securities are as bad as I think, they should not be treated as securities but as intrinsically-defective instruments for which no market is likely to revive. Nor should it. Unless there was an actual audit or decent sample of the loan tapes behind the mortgages, we won't know for sure. I will continue to suspect that Treasury is resisting this step because it doesn't want to know what the evidence would show.