Banking system still faces rough road ahead

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

News that 10 big banks will repay $68 billion in government bailout funds is being hailed as a key milestone on the road to a recovery for the battered banking system. But despite clear signs of improvement, the road is still full of potential potholes — especially for weaker banks that haven’t been able to replace government-provided capital with private investment.

The banks, led by JPMorgan, Morgan Stanley and Goldman Sachs, got the green light Tuesday to hand the money back, after passing a government “stress test,” raising fresh capital and satisfying regulators that they’re strong enough to ride out the recession. Another nine large stress-tested banks are keeping the government funds for now, as are several hundred smaller banks that got so-called TARP funds.

But with unemployment rising and home prices falling, it’s not clear whether the stress test was stressful enough. Assumptions about the “worst case” economic scenario — made when the test was designed in February — turned out to be too optimistic, according to Elizabeth Warren, head of the Congressional Oversight Panel set up to oversee the bank bailout.

“We've already blown past the worst-case scenario on unemployment,” she said on CNBC this week. “That means it's time to rerun those numbers and find out if the stress test is strong enough to give us a  good prediction and tell us these financial institutions are solid even if unemployment is higher than the model predicted.”

Some of the biggest banks were reluctant to take government funding from the beginning and have chafed under restrictions on pay packages and other strings that came attached to the Treasury’s billions. Now, some observers fear the bankers may be too eager to get out from under the government’s support.

“I think it's way too premature,” said former Citigroup senior executive Carl Levinson. “I think the (banks’) first-quarter earnings were overstated through trading profits. And there’s nothing wrong with waiting at least another quarter — or maybe even two. Because the worst thing that can happen is a double-dip recession and we go back down again.”

To win Treasury permission to pay back funds from the Troubled Asset Relief Program, or TARP, the banks had to lay out a plan to show how they could raise enough money to rebuild their capital base. Much of that money is expected to come from bank profits, which were surprisingly strong in the first three months of 2009.

Though the economy is showing signs of bottoming, heavy losses on credit cards and commercial loans could continue to weigh on bank profits well into next year.

The TARP program has had only mixed success in its original intent: to free up credit and get banks lending again. Financial markets have stabilized since last September, and fears of a wider collapse have eased along with the cost of lending. And banks have raised more than  $100 billion in private capital so far this year to boost their capital base.

But lending activity is still below levels normally seen in a healthy economy.

"The lending capacity is there,” said Tom Brown, an industry analyst at Bankstocks.com. “What is needed is the economy to continue to show signs of recovering and then business borrowing coming back.”

The TARP was originally created to buy bonds and other securities backed by mortgages that produced huge losses. But the Treasury couldn’t figure out how to value the assets because so many homeowners are continue to default on their mortgages.

Instead the government structured the bailout funding as a special preferred stock that could be switched into common — automatically by the government — if and when a bank’s capital fell below required minimums.

But the TARP funds did little to directly spur more lending — largely because banks have to pay 5 percent interest on the money.

“That  means they have to lend the  money at more than 7 percent pre-tax to break even,” said Richard Bove, an industry analyst with Rochdale Securities. “And they can't do that. It doesn't  make sense for these companies to hold on to TARP money because they can't make money.”

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