Stress test results lift cloud of uncertainty

Results show 10 big banks need $75 billion in new capital; hope rises for economy’s recovery

Daniel Wagner and Jeannine Aversa, AP Business Writers
Friday May 8, 2009, 1:09 am EDT

WASHINGTON (AP) — Government exams of the biggest U.S. banks have helped lift a cloud of uncertainty that has hung over the economy.

The so-called stress tests — a key Obama administration effort to boost confidence in the financial system — showed nine of the 19 biggest banks have enough capital to withstand a deeper recession. Ten must raise a total of $75 billion in new capital to withstand possible future losses.

“The publication of the stress tests simply cleared the air of uncertainty,” said Allen Sinai, chief global economist at Decision Economics. “The results were not scary at all.”

He said it will take a long time for the banks to resume normal lending. But the test results didn’t alter his prediction that economy is headed for a recovery in October or November.

A key indicator of economic health will be released Friday morning, when the government announces how many more jobs were lost in April and how high the unemployment rate rose.

The stress tests have been criticized as a confidence-building exercise whose relatively rosy outcome was inevitable. But the information, which leaked out all week, was enough to cheer investors. They pushed bank stocks higher Wednesday, and rallied again in after-hours trading late Thursday once the results had been released.

Among the 10 banks that need to raise more capital, Bank of America Corp. (BAC) needs by far the most — $33.9 billion. Wells Fargo & Co. (WFC) needs $13.7 billion, GMAC LLC $11.5 billion, Citigroup Inc. (C) $5.5 billion and Morgan Stanley (MS) $1.8 billion.

The five other firms found to need more of a capital cushion are all regional banks — Regions Financial Corp. (RF) of Birmingham, Alabama; SunTrust Banks Inc. (STI) of Atlanta; KeyCorp (KEY) of Cleveland; Fifth Third Bancorp (FITB) of Cincinnati; and PNC Financial Services Group Inc. (PNC) of Pittsburgh.

The banks will have until June 8 to develop a plan and have it approved by their regulators. If they can’t raise the money on their own, the government said it’s prepared to dip further into its bailout fund.

The stress tests are a big part of the Obama administration’s plan to fortify the financial system. As home prices fell and foreclosures increased, banks took huge hits on mortgages and mortgage-related securities they were holding.

The government hopes the stress tests will restore investors’ confidence that not all banks are weak, and that even those that are can be strengthened. They have said none of the banks will be allowed to fail.

Among the banks that the government did not ask to raise more capital were JPMorgan Chase & Co. (JPM), brokerage house Goldman Sachs Group Inc. (GS), insurer MetLife Inc. (MET) and credit card companies Capital One Financial Corp. (COF) and American Express Co. (AXP)

Together, the 19 firms that took the test hold two-thirds of the assets and half the loans in the U.S. banking system.

Wells Fargo and Morgan Stanley said they’ll try to raise billions in fresh capital. Meanwhile, American Express became the first major financial institution to formally request permission to return federal bailout money provided under the Troubled Asset Relief Program, or TARP.

Separately, Citigroup said it’s planning to convert an extra $5.5 billion of preferred shares — a kind of debt — into common stock after the stress tests determined it needs an equal amount in fresh capital.

GMAC said it will raise the $11.5 billion mandated by the Treasury within six months, a task that could involve the federal government taking a big stake in the auto finance company.

The Treasury lent GMAC $5 billion from the Troubled Asset Relief Program in December after granting the company’s request to become a bank. In exchange, the government received preferred stock. In a statement Thursday, GMAC said one option for raising the capital was for it to convert “existing equity into a form of Tier 1 common equity.”

GMAC, which reported a first-quarter loss of $675 million, said earlier this week it has seen rising defaults in its auto finance division. That, combined with soured assets in its Residential Capital LLC mortgage unit, makes it more difficult for the company to raise the additional capital in the public markets.

The tests found that if the recession were to worsen, losses at the 19 stress-tested firms during 2009 and 2010 could total $600 billion. Of those losses, $185.5 billion would be from mortgages, $82.4 billion from credit card loans and $53 billion from commercial real estate loans — the loans on banks’ books that analysts say are now most vulnerable to default.

“Looking at the big picture, you can say that things aren’t so bad for the financial industry as a whole,” said Kevin Logan, chief U.S. economist at Dresdner Kleinwort.

But Logan said attracting fresh capital will be a challenge for banks that need it.

“The banking industry is not going to make a lot of money going forward, and that’s a dilemma for keeping banks solvent and getting them lending,” he said.

Large and regional bank stocks mostly rallied in after-hours trading as investors showed relief over the results. Bank of America rose 9.2 percent to $14.75, while JPMorgan gained 1.5 percent to $35.77. Fifth Third Bancorp advanced 23.4 percent to $6.60, while Boston’s State Street Corp. (STT)s jumped to $40.90, a gain of 8.1 percent.

The government’s unprecedented decision to publicly release bank exams has led some critics to question whether the findings are credible. Some said regulators seemed so intent on sustaining public confidence in the banks that the results would have to find the banks basically healthy, even if some need to raise more capital.

Jaidev Iyer, a former risk management chief at Citigroup, said regulators are playing to public expectations, which could put the government in the role of creating “winners and losers.” Because the government has said it won’t let any firm fold, taxpayers may wind up on the hook.

In the tests, the Fed put banks through a scenario that imagines how they would fare if the recession worsened. It imagined that joblessness would hit 10.3 percent next year and house prices would fall more than 22 percent.

Some analysts have questioned whether the tests were rigorous enough. For example, economists expect the jobless rate to approach or exceed 10 percent by year’s end — and to go higher next year — even if the recession doesn’t worsen.

A steeper downturn would make it harder for consumers and businesses to repay loans, which would cause banks’ assets to lose value. The government is forcing the banks to keep their capital reserves up so they can keep lending even if the economic picture darkens.

The tests measured bank reserves based on what’s known as common equity, the value of a company’s common stock and profits. Some of the banks have big enough reserves by traditional measures but fall short by this narrower standard.

“It’s not really stressful, so how could it be a stress test?” said Simon Johnson, a former chief economist with the International Monetary Fund and professor at the Massachusetts Institute of Technology. “This makes it seem like we’re not having a financial crisis at all.”

Banks that need capital have several options. Some would be able to close the gap by converting the government’s debt into common stock.

“These tests will help ensure that banks have a sufficient capital cushion to continue lending in a more adverse economic scenario,” said Treasury Secretary Timothy Geithner. “They will provide the transparency necessary for individuals and markets to judge the strength of the banking system.”

Describing the purpose of the tests, Federal Reserve Chairman Ben Bernanke said at a news conference with Geithner, “This is to make sure banks have enough capital to offset the losses we know are coming in the next couple of years.”

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