Bank tests bring a new set of stresses

John W. Schoen Senior producer • Profile • E-mail

Fed Chairman Ben Bernanke has said he hopes the bank "stress tests" will help the "healing process" for Wall Street and the economy. Hope springs eternal.

The results of the Treasury’s tests on banks have leaked out piecemeal, and instead of soothing nerves, the exercise has produced a number of unintended consequences, among them more stress for depositors and investors.

The original idea was to head off another bank meltdown that could send the financial markets back into a panic mode similar to last fall when Lehman Brothers collapsed. But conflicting information about the results and what they mean has produced a new series of headaches for banks, regulators and the public.

It has also left unsolved some of the fundamental problems the program was designed to address, and may leave some banks worse off when the process is over.

“I think when they announced this in February, they did that more to calm the markets,” said Cam Fine, CEO of the Independent Community Bankers of America. “They weren't really thinking about the end game and the exit strategy. And now they have to deal with this, and they're really in a lose-lose situation.”

The basic outlines of the process are pretty simple. With banks holding billions of dollars of loans and assets backed by real estate, and the real estate market still in decline, bankers have a hard time selling those assets, or even figuring out how much they’re worth. If the housing market and the economy recover later this year, those assets will be worth more than they would be if the recession grinds on and real estate prices continue to fall. No one knows how long that recovery will take.

Some banks have so many “toxic” assets that they don’t have enough capital to cover losses in the worst-case economic scenario. That’s forcing some banks to hoard cash that would otherwise be used to make new loans, which in turn would help spur business and create jobs.

To shore the banks up, the Treasury last fall swapped roughly $200 billion in cash for a special interest-bearing stock in the biggest and most troubled banks. Regulators then set about trying to find out exactly how much capital the 19 largest banks would need to weather a rough economic storm.

After meticulously analyzing the impact of a deeper recession on these risky bank assets, the Treasury is now telling about half of those banks they need to raise more capital. Published reports indicate that Bank of America, Wells Fargo and Citibank are among those being told to add tens of billions to their capital cushion.

These banks have two choices to bolster their capital. First, they can sell assets or issue more common stock on their own. The Treasury is giving them a deadline of six months to raise the money. If they can’t raise the capital , the Treasury says it will step in with Plan B, which involves converting the government's special preferred shares into common stock, effectively taking partial ownership of the weakest banks.

But as the government singles out which banks need more capital, it risks making it harder — and more expensive — for those banks to raise the money they need.

“For the shareholders of Wells Fargo or Bank of America, I think it's an outrage,” said Frederick Lane, a Boston-based investment banker. “What's happening, of course, if equity needs to be raised, it's going to be raised under perceived duress. Having these banks sell into a firestorm is difficult.”

Bank stocks have gotten pummeled since the financial crisis began last year, losing more than half their value overall. Bank of America and Citigroup, among the hardest hit, have seen their stock prices collapse by more than 90 percent. That makes it even harder to raise capital by selling fresh stock; the more new shares they sell, the less each share will be worth. (That’s because issuing new stock dilutes the ownership of existing shareholders.)

Some have argued that the “stress test” wasn’t needed in the first place. Private institutional investors do their own analysis of banks’ book before deciding whether to buy shares. Bank regulators routinely review the books of individual banks and require them to keep a minimum level of reserves on hand.

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