The Bank Stress Test - Maybe Another $0.6 T To Go

Below is a summary of the bank stress test performed by various bank regulators. As is to be expected the results are controversial at best. The optimists have found reasons to be happy, the pessimists have found reasons to be unhappy, and the people familar with the banking industry understand how flawed the analysis was. Both President Obama and Secretary Geithner may not appreciate how much of their reputation is riding of these types of tests. Be careful the American people are watching and they are not happy.

A couple of things I find interesting about this: 1) everyone is mad at B of A because they need relatively large equity injections, but evryone forgets that B of A came to the rescue of the finacial system twice: once when they picked-up Countrywide and a second time when they picked-up Merrill Lynch. Both these companies were in really bad shape and needed to be absorbed. 2) Wells Fargo needs more money, but they in turn picked up a really sick bank in Wachovia. Same issue as B of A. 3) another bank (un-named) comes out clean in this process in part because it received part of the AIG bail-out money, when AIG paid off some of their obligations. And 4) Most of the commercial real estate loans in this country are made by the small local and regional banks. This portion of the economy is just starting to unravel. Obviously, with only 19 banks tested this portion of the industry was not even addressed with this stress test.

Text in bold is my emphasis. From the WSJ:

The federal government projected that 19 of the nation's biggest banks could suffer losses of up to $599 billion through the end of next year if the economy performs worse than expected and ordered 10 of them to raise a combined $74.6 billion in capital to cushion themselves.

The much-anticipated stress-test results unleashed a scramble by the weakest banks to find money and a push by the strongest ones to escape the government shadow of taxpayer-funded rescues.

The Federal Reserve's worst-case estimates of banks' total losses and capital shortfalls were smaller than some had feared. Optimists interpreted the Fed's findings as evidence that the worst is over for the industry. But questions remain about the stress tests' rigor, in part since the Fed scaled back some projected losses in the face of pressure from banks.

The government's tests measured potential losses on mortgages, commercial loans, securities and other assets held by the stress-tested banks, ranging from giants Bank of America Corp. and Citigroup Inc. to regional institutions such as SunTrust Banks Inc. and Fifth Third Bancorp. The government's "more adverse" scenario includes two-year cumulative losses of 9.1% on total loans, worse than the peak losses of the 1930s.

Treasury Secretary Timothy Geithner said Thursday that he is "reasonably confident" that banks will be able to plug the capital holes through private infusions, alleviating the need for Washington to further enmesh itself in the banking system.

Banks also said they will consider selling businesses or issuing new stock to meet the toughened capital standards.

The information provided by the stress tests will "make it easier for banks to raise new equity from private sources," Mr. Geithner said. Still, he added, "We have a lot of work to do...in repairing the financial system."

Some of the banks told to add capital raced to accomplish that by tapping public markets. On Thursday, Wells Fargo & Co., which the Fed said needed to raise $13.7 billion, laid plans for a $6 billion common-stock offering. Morgan Stanley, facing a $1.8 billion deficit, said it will sell $2 billion of stock and $3 billion of debt that isn't guaranteed by the U.S. government.

If successful, the offerings "should be a meaningful step in restoring a modicum of confidence to the banks," said David A. Havens, a managing director at Hexagon Securities. "It indicates that even the big messy banks are able to attract private capital."

Shares of more than a dozen stress-tested banks rose in after-hours trading as the government's announcement soothed jitters about the industry's immediate capital needs. Bank of America shares climbed 3.6% to $13.99, while Citigroup was up 6.3% to $4.05. Fifth Third jumped 19% to $6.35. SunTrust fell 2.5% to $18.05, and Wells Fargo slipped 0.9% to $24.54.

Nine of the stress-tested banks -- including titans like J.P. Morgan Chase & Co. and Wall Street's Goldman Sachs Group Inc. as well as several regional institutions -- have adequate capital. That finding essentially represents a seal of approval from the Fed.

The others need to raise anywhere from about $600 million for PNC Financial Services Group Inc. to $33.9 billion for Bank of America. In between are several other regional lenders: Fifth Third, which needs to raise $1.1 billion; KeyCorp, $1.8 billion; Regions Financial Corp., $2.5 billion; and SunTrust, $2.2 billion.

Experts warn that the tests could have a serious unintended consequence: Loans could be harder to come by for consumers and businesses. That's because the government's intense focus on thicker capital cushions might prompt banks to hoard cash and further curtail lending, said Jim Eckenrode, banking research executive at TowerGroup, a financial consulting firm. He said banks will have less room to offer consumers low interest rates, while corporate customers may have a tougher time getting financing for commercial real-estate and property development.

That would undercut a key goal of the Obama administration, which has been pushing banks to lend more in order to jump-start the economy.

The test results were vigorously contested by some banks, which argued they were superficial and didn't reflect significant differences in the health of various banks' loan portfolios.

In a news release Thursday, Regions publicly criticized the testing process. The Birmingham, Ala., bank said the Fed's loss assumptions were "unrealistically high." Regions said it "questions whether it should be required to raise additional capital now to provide for a two-year adverse economic scenario," given recent hints that the economy may have hit bottom.

With the tests complete, Washington's effort to clean up the banking system now shifts into a new, potentially messy phase. While most of the banks that need capital are likely to be able to find it, analysts and bankers say a few others are likely to end up being largely owned by the U.S. government due to their inability to raise capital from private investors.

Meanwhile, the tests don't address a sea of problems confronting many midsize and smaller banks.

Federal officials have repeatedly vowed to support the 19 banks, which essentially have been labeled too big to fail. Those reassurances have propelled the companies' shares to their highest levels in months. The White House, Treasury Department and Fed hope that by restoring confidence in the industry, private investors will help troubled banks shore up their finances, eliminating the need for taxpayer-financed rescues.

There are some encouraging signs. In recent weeks, a handful of healthy banks -- ranging from giants like Goldman Sachs to Denver's 34-branch Guaranty Bancorp -- have raised money by selling stock in public offerings. That represents a seismic shift from earlier this year, when many investors refused to touch any bank stocks.

"What we're starting to hear from investors is a view that these companies were oversold and, although things are bad, they're not as bad as was baked into the assumptions," said Brian Sterling, co-head of investment banking at Sandler O'Neill & Partners in New York.

Some Fed-blessed banks are likely to pursue public equity or debt offerings to flex their financial muscles and help pay back the funds that the government invested in them.

State Street Corp. Chairman and Chief Executive Ronald E. Logue said the government's conclusion that the Boston company needs no additional capital puts it "in a position to consider repayment of the TARP preferred stock and warrants under the appropriate circumstances."
State Street, one of the largest managers of index funds, got a $2 billion taxpayer-funded infusion under the Troubled Asset Relief Program, or TARP. On Wednesday, The Wall Street Journal incorrectly reported that State Street had been told to come up with more capital.
Bankers acknowledge that investors' appetites are limited. Investors say not enough private funds are available to fill the big banks' financial holes.

"I think there is some demand in the market to raise a certain amount, but whether you could find $60 billion of capital in the next couple of months is highly unlikely," said Joshua Siegel, managing principal at StoneCastle Partners LLC, a New York firm that invests in banks.

Banks that can't coax private investors have some other options. They can sell assets or business lines, a strategy already under way at Bank of America and Citigroup. They can push investors to swap so-called preferred shares for common stock, padding a measure of capital known as tangible common equity.

During a Thursday conference with investors, Bank of America Chief Executive Kenneth Lewis said, "Our game plan is designed to help get the government out of our bank as quickly as possible," and vowed to abandon a loss-sharing agreement with the U.S. on $118 billion in assets.

But bankers and analysts say at least a few lenders are in a vise. Too weak to lure investors, and lacking a large pool of privately held preferred stock, these banks likely will have to turn to Washington for help. Fifth Third and Regions both said in statements Thursday that they hope to raise private funds.

The 19 tested banks, which all have at least $100 billion in assets, accounted for most of the industry's total loans. But the companies represent a sliver of the roughly 8,000 banks nationwide.

Among that vast field, many banks -- from regional institutions to tiny community lenders -- are holding huge portfolios of rapidly souring loans. Unlike their larger rivals, these banks lack the diverse income streams to overcome the brutal operating environment.

Analysts at RBC Capital Markets estimate that 60% of the top 100 U.S. banks that weren't included in the stress tests would need to raise new capital based on the Fed's loss assumptions.