Federal regulators have now released their “stress test” evaluations of America’s 19 largest banks. How many of the 19 thrifts are adequately capitalized? Which banks will be directed to boost their capital, and where might that capital come from?
Information has been leaking for weeks and the Administration explicitly mentioned Citi (C)and Bank of America (BAC) and needing more capital. But, now we have the official report and the Federal Reserve’s opinion.
Nine banks won't be required to raise more capital. The banks in the best shape: American Express (AXP), BB&T (BBT), Bank of New York Mellon (BK), Capital One Financial (COF), Goldman Sachs (GS), JPMorgan (JPM), MetLife (MET), State Street (STT) and US Bancorp (USB). The government says these banks do not need to raise money from new investors.
Ten others need to raise capital or face effective nationalization. These banks need to raise new capital or bolster capital reserves by the following amounts: Bank of America (BAC) ($33.9 billion), Citigroup (C) ($5.5 billion), Fifth Third Bancorp (FITB) ($1.1 billion), GMAC LLC ($11.5 billion), KeyCorp (KEY) ($1.8 billion), Morgan Stanley (MS) ($1.8 billion), PNC Financial Services (FNC) ($0.6 billion), Regions Financial (RF) ($2.5 billion), SunTrust Banks (STI) ($2.2 billion) and Wells Fargo (WFC) ($13.7 billion).
The only real surprise here was Wells Fargo, which as early as last weekend had Warren Buffet singing the company's praises at the annual Berkshire Hathaway investor meeting.
The government has given the banks that do need capital up to six months to raise it – and one month to come up with a plan to do so. June 8 is the plan deadline and November 9 is the deadline for raising money. Some may raise all the capital they need by converting government debt into private stock. But this will mean making the government a major or majority shareholder.
Under the conditions of the tests, the Fed wanted to see at least 6% of their assets in in the most liquid ("Tier 1") capital and at least 4% in common equity by 2010 under the two economic scenarios posed. Tier 1 capital includes common shares, most types of preferred stock, and TARP funds.
The worst case scenario assumed a fairly high rate of foreclosure, but also expected high levels of profitability by the banks through a worsening climate, which is a somewhat controversial position. What is probably the most compelling criticism of the tests though is that the different risk management models of the banks themselves (which were presumably pretty flawed to begin with) are what have been relied upon to reveal the expected capital position of the banks in these two scenarios.
Ultimately, the great weakness of the Treasury's approach is that, if the last year has taught us anything - attempts to model a realistic "worst case scenario" for anything over a very short period is virtually impossible. This is not what the Stress Tests really are about anyway - they are an orchestrated effort to restore investor confidence and change sentiment. It is apparently, so far, effective, in that it has substantially reduced bank debt interest rates in the private markets.
Banks that need to thicken their capital cushion can do so by 1) selling selected assets, 2) raising new common equity from current shareholders or new investors, 3) applying any earnings that top analyst expectations toward their capital bases, or 4) converting preferred shares into common stock. Step 4 is actually a cash conservation move – converting the preferred shares wouldn’t actually boost overall capital, but it would allow banks to eliminate preferred stock dividends.
Consolidation is likely. Several analysts project the smaller banks among the 19 – thrifts such as SunTrust, Fifth Third, Regions Financial and KeyCorp – could end up merging with larger banks.
The Treasury is the lender of last resort. The government has instructed the banks to go to the private sector first before asking for any more federal money. Treasury Secretary Tim Geithner projects the “vast bulk” of thrifts needing more capital can capably raise it “through private sources”. The still-developing Public-Private Investment Program (PPIP) could offer a way. But, its reasonable to expect that Citi and Bank of America will find it very challenging to raise significant capital in this environment and will likely have to accept strong US government influence on their boards.
Stress tests have occurred for years in the banking world; the findings of such tests are commonly kept private. The government revealed these results with the goal of maintaining the public’s faith in the banking system – as if to say, “Here is the open book and here is how we are directing the banks to make things better.”
Some analysts wonder how credible the results are. After all, what would the government have to gain by saying a big bank was in big trouble? Investors would flee, and the Treasury would have to shell out more TARP money. Other analysts note that generating capital and bettering the balance sheet doesn’t address the problem of removing toxic assets from the books of these banks.
On the other hand, the announcement of the stress tests did lessen the anxiety among investors this winter, when Wall Street fretted about the possibility of bank nationalization. The announced results do not look as negative as some investors had expected. Interviewed May 6 on Charlie Rose’s PBS program, Secretary Geithner noted that there are “very significant cushions in these institutions today, and all Americans should be confident that these institutions are going to be viable institutions going forward.”
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