Bank Stress Tests: The Results Are in; Now What?

By Jason Simpkins
Managing Editor
Money Morning

The results of the government’s bank stress tests were released yesterday (Thursday), and the U.S. Federal Reserve has directed 10 banks to raise an aggregate $70 billion-plus in capital. Banks that require funding will have 30 days to present a capital-raising strategy to regulators and then six months to implement it.

It is unlikely that any of the banks will require any additional taxpayer money.

J.P. Morgan Chase & Co. (NYSE: JPM), Goldman Sachs Group Inc. (NYSE: GS), MetLife Inc. (NYSE: MET), American Express Co. (NYSE: AXP), Bank of New York Mellon Corp. (NYSE: BK), BB&T Corp. (NYSE: BBT), Capital One Financial Corp. (NYSE: COF), U.S. Bancorp (NYSE: USB), and State Street Corp. (NYSE: STT) are in the clear in terms of having adequate capital cushioning.

The following banks will be required to raise these assigned amounts of capital:

• Bank of America Corp. (NYSE: BAC): $34 billion.
• Wells Fargo & Co. (NYSE: WFC): $13.7 billion.
• GMAC LLC (NYSE: GMA): $11.5 billion.
• Citigroup Inc. (NYSE: C): $5.5 billion.
• Morgan Stanley (NYSE: MS): $1.8 billion.
• Fifth Third Bancorp (NASDAQ: FITB): $1.1 billion.
• KeyCorp (NYSE: KEY): $1.8 billion.
• PNC Financial Services (NYSE: PNC): $600 million.
• Regions Financial Corp. (NYSE: RF): $2.5 billion.
• SunTrust Banks Inc.( NYSE: STI): $2.2 billion.

The banks will have until June 8 to develop a plan to raise the required capital and until Nov. 9 to implement it. They may choose to raise the money in a variety of ways. They may sell assets, court private investment or convert the government’s existing preferred shares into common stock.

Citigroup has already announced plans to convert a portion of the government’s $45 billion stake into common stock, a move that will give the federal government a 36% stake in the company. Other regional banks – such as Fifth Third Bank or Regions Financial – could be forced to take similar actions, but are loath to do so, as most of the moves would be dilutive to existing shareholders.

Citigroup has agreed to sell Nikko Cordial Securities to Sumitomo Mitsui Financial Group (OTC: SMFJY) for about $5.5 billion. The deal, which is to be completed by Oct. 1, is expected to boost the bank’s Tier-1 capital ratio by approximately 27 basis points.

Morgan Stanley plans to close its capital gap by selling assets or stock to private investors, a person briefed on the plan told The New York Times. And Wells Fargo said late yesterday that it plans to sell $6 billion in new common stock in an effort to raise required capital.

While Bank of America has said it doesn’t agree with the Fed’s conclusions, the bank yesterday outlined its strategy to accommodate the government’s demands. BofA is exploring the sale of such business units as its First Republic private-banking unit and asset manager Columbia Management, The Wall Street Journal reported.

The sale of those businesses could raise a combined $4 billion, David Hendler of CreditSights Inc. told The Journal. BofA could also get about $8 billion for its partial stake in China Construction Bank Corp.

Beyond that BofA would have the options of converting the government’s existing $45 billion investment, or $33 billion in private preferred shares, into common stock.

The Fed wants bank-holding companies to achieve a Tier 1 risk-based ratio of at least 6%, and a Tier 1 Common risk-based ratio of at least 4% by the end of 2010. The goal is to get banks to the point where they are stable enough that they can borrow from private investors without a Federal Deposit Insurance Corp. (FDIC) guarantee, people familiar with the matter told Bloomberg News.

“Going forward, we just need banks to be able to issue debt without the FDIC backing – that’s the next stage for these bank names in terms of evaluating their health,” Mark Bronzo, a money manager at Security Global Investors LLC, which oversees $21 billion in Irvington, N.Y., told Bloomberg.

If the banks fail to meet capital requirements, the government will step in to provide the necessary funds. However, it’s unlikely that any more taxpayer money will be needed, as about $110 billion of the original $700 billion in Troubled Asset Relief Program (TARP) funding remains.

Wall Street’s Reaction

The Dow Jones Industrial Average closed down 102.43 points, or 1.2%, yesterday, with the Dow Jones U.S. Financial Services Index down 3.78%. However, Wall Street’s reaction to the tests won’t be fully realized until the market opens later today (Friday).

"I think this will be a confidence-instilling announcement," Federal Deposit Insurance Corp. Chairman Sheila Bair told a Senate panel Wednesday. "There will be additional needs for capital buffers for some institutions, but I think there will be mechanisms to do that within the next six months."

Treasury Secretary Timothy F. Geithner said in an interview with PBS television’s “The Charlie Rose Show” that all of the institutions tested already have “significant cushions” of capital and that Americans have every reason to be confident going forward.

“The results will be, on balance, reassuring,” Geithner said.

But some analysts are skeptical about what the bank stress tests actually achieved, or if their standards of evaluation were even valid in the first place. After all, the tests have occupied resources from both the federal government and the private sector for months, and have increased stock market volatility.

“The banks are healing themselves, and it could have been done a lot faster if government had gotten out of the way instead of parking the emergency equipment in the middle of the road,” Gary B. Townsend, a former banking regulator who now runs his own investment firm, told The New York Times.

Also, many bank employees, and even Elizabeth Warren, who chairs the Congressional Oversight Panel for TARP, have expressed concern that the tests weren’t stringent enough.

Last month, Warren gave rise to speculation that another stress test might be needed by the end of the year, after she called the adverse economic scenario employed by the Fed “disturbingly close” to current economic conditions.

In the Fed’s most pessimistic economic forecast, for example, the government projects the unemployment rate will climb to 10.3% in 2010. But unemployment already hit 8.5% in March and many economists are predicting that it rose to 8.9% in April. If that’s the case, it’s not hard to imagine the national jobless rate reaching double digits by the end of the year.

“The stress tests will make a terrific contribution if they are tough and transparent,” Warren said. “If they are not, they will be useless.”

Still, despite the test’s alleged failings, there is a hope that with more transparency and a greater buffer of equity, investor confidence will be restored.

“This is sending a message that the banks need more capital, but their losses are manageable and the system itself is solvent,” Kevin Fitzsimmons, an analyst at Sandler O’Neill told The Times. “Whether it sticks is something else.”

News and Related Story Links:

• Federal Reserve:
  The Supervisory Capital Assessment Program: Overview of Results
• Bloomberg:
  Fed’s Bank Results ‘Reassuring,’ Show No Insolvency
• NY Times:
  Banks Need Funds, but Taxpayers May Not Have to Pay
• Wall Street Journal:
  Banks Need at Least $65 Billion in Capital
• Money Morning:
  Bank Stress Tests Turn Up 10 Banks That Need More Capital
• Money Morning:
  Money Morning’s Bank Stress Test Says These Three Banks Are the Strongest
• Money Morning:
  Bank of America, Citigroup Told to Boost Capital as Validity of Bank Stress Tests Is Called Into Question