Stress Tests Put Obama Administration in "No-Win" Situation

By Don Miller
Associate Editor
Money Morning

The Obama administration may have backed itself into a corner when it released the details of the "stress test" methodology being used to evaluate the health of the nation's big banks. 

With final results not expected to be released until May 4, releasing the testing methods for Citigroup Inc. (C), JPMorgan Chase & Co. (JPM), Bank of America Corp. (BAC), and 16 other banks is only likely to increase market speculation – the exact result Obama's economic team is trying to avoid.

Releasing the formula may also lead analysts to compare the test criteria to public financial data and start to draw their own conclusions about which banks are likely to fail or will require massive infusions of additional capital.

"They've gotten themselves in a pickle on this thing," said Bert Ely, an independent banking analyst. "It's clear they didn't think through how this was going to play out."
The stress tests are based on two scenarios: One assumes current forecasts for the recession are correct and that the unemployment rate will remain at 8.8%, while the other projects conditions will deteriorate with unemployment climbing as high as 10.3%, according to documents released by the U.S. Federal Reserve.  The tests are being used to determine if banks have enough money reserved to withstand further losses under either scenario.

The administration has said no banks will fail the test, but if they fall short, regulators will force them to boost their capital. If they can't raise the funds through private sources in six months, the government will step in with funds to shore up operations at the banks that are deemed too big to fail.

Part of the tests will focus on loan quality as a measure of health. Commercial loans in default or foreclosure soared to $65.9 billion in the first quarter, up 43% from $46 billion at year-end, according to New York-based research firm Real Capital Analytics Inc. Property values have fallen at least 30% since their 2007 peak.
U.S. banks have reported more than $550 billion in writedowns, losses and credit provisions since 2007, according to Bloomberg data. Banks have raised more than $400 billion from private investors and the government to guard against loan losses as mortgage defaults surged.

Federal Reserve officials disseminated preliminary results to representatives of the banks on Friday.   KBW Inc. (KBW) issued a report on April 23 that said lenders may need to raise $1 trillion in capital to cushion losses.

The fear is that speculation will only increase after the release of the testing criteria, which may cause a run on banks with capital needs.  That could make it harder for them to persuade investors to give them cash.

"We're really hesitant to put money into financials," Douglas Ciocca, a managing director at Renaissance Financial Corp. in Leawood, Kansas, told Bloomberg News. 

"The ambiguity is still engulfing the opportunity."

Regulatory bank reviews are normally kept secret to avoid shaking up investors and customers who may race to withdraw their money.  The administration is trying to  maintain a delicate balance between revealing too much – which could destabilize weaker banks – or saying too little, leading the public to assume the government is whitewashing the results. 

The tests are at the center of the Obama administration's plan to stabilize the financial system. Officials have been refusing to answer questions about the banking system for months saying they're awaiting the test results.

Officials are trying to release enough information to give investors confidence. But they don't want to give analysts so much detail that they can run their own tests on the banks before the official release of results.

The slow-motion rollout is intended to tame market reaction to the news but that might backfire as well.

"It's a week plus until we find out, that's where the danger is," said Anton Schutz, president of Mendon Capital Advisors Corp. in Rochester, New York, which manages $150 million of financial stocks, told Bloomberg. "You get market movement on what might be fact or fiction," he said.

Further complications may arise when the government releases final results on May 4 because the Obama administration may ask banks that need more capital to disclose how they plan to get additional funds.

In a report on the tests last week titled "Total Confusion," analyst Richard X. Bove of Rochdale Securities contended that the government is in a no-win situation because there was "no effective way to communicate the results of this test without causing greater stress than the test itself," the Times reported.

News and Related Story Links:

• Los Angeles Times:
  Bank bailout plan's 'stress tests' already causing stress

• Bloomberg:
  Stress-Tested Banks May Struggle as Bad Assets Triple