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Stress Reduction: Bank Results Loom

Bank of America, Citi, and Wells Fargo are expected to lead the group needing fresh capital to meet the government's worst-case scenario

After fits and starts, the Treasury Dept. on May 7 will finally release the outcome of its stress tests conducted on the 19 largest U.S. banks. The report is expected to show that Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), and other big financial institutions need to raise billions of dollars of new capital to withstand various adverse scenarios, including 10.3% unemployment and a 22% drop in home prices during the next two years.

BofA is poised to top the list of banks that need the most capital, at near $35 billion, because of its huge exposure to the consumer lending business, home mortgages, and credit cards, according to reports in The Wall Street Journal and elsewhere. The bank also has a portfolio of construction and commercial real estate loans that trumps those of JPMorgan Chase (JPM) and Citi. Still, despite the need for more capital, equity investors seemed to heave a sigh of relief on the eve of the announcement as the numbers appear below analysts' worst fears: New York bond shop CreditSights, for instance, had pegged the worst-case number for BofA at $39 billion. BofA's stock price closed up 17%, at 12.69.

"If you were afraid it was going to be $40 billion or $70 billion, and then you're thinking this isn't so bad," says Maureen O'Hara, professor of finance at Cornell University's Johnson Graduate School of Management. "It's hard to believe that $35 billion is good news, but it shows how much uncertainty has been out there."

Based on Guesswork

Some doubt Thursday's results will even begin to dispel that uncertainty surrounding some of the big banks, and some say the government's worst-case scenario forecasts may not be dire enough. "Nobody really knows. Everybody is basing their estimates on capital needs based upon their forecasts on what the economy and earnings capacity," says John Douglas, former general counsel of the Federal Deposit Insurance Corp. and current chair of the Banking & Financial Institutions Group at international law firm Paul Hastings. "These are all guesses. Some are more educated, but they are all guesses."

The results will no doubt produce winners and losers, both in the marketplace and among investors. Leaks out of Washington have pointed to Citi, BofA, and Wells Fargo as the big banks in the most precarious position that need to shore up their capital base. GMAC, the auto-financing giant, reportedly needs $11.5 billion. Those that appear to be getting a pass include Morgan Stanley (MS), JPMorgan Chase, Goldman Sachs (GS), and MetLife (MET).

The financial institutions that are deemed undercapitalized on Thursday will have to present a plan to the government within a month on how they will get up to snuff, and then raise the capital within six months.

So where are banks like BofA going to get the extra money? Many are expected to convert preferred shares held by the government or other lenders into common stock. Doing so would avoid returning to Congress for more bailout money. It would serve to boost so-called Tier 1 capital, which is the capital about which regulators are most concerned. The thinking behind such a conversion is that if a bank incurs losses, it hits the common shareholders first. Thus regulators and the investors want a large cushion of common equity to absorb unforeseen losses, explains Sung Won Sohn of the Smith School at California State University Channel Islands.

Once Burned, Twice Shy

Still, the conversion process doesn't impress sophisticated investors. "The bank looks better on paper, but there isn't really new money coming in," says Michael Shuster, leading securities litigation partner at Kasowitz, Benson, Torres & Friedman. "I don't think sophisticated investors, like hedge funds and private equity investors, are going to be particularly impressed or feel any more confidence in the soundness of the financial institutions by virtue of [changing] a stock from preferred to equity."

Moreover, many institutional investors—such as sovereign wealth funds—may be reluctant to buy up bank stocks after getting burned by such investments in the recent past. "The question is who is going to want to take positions," wonders O'Hara. "A lot of people are nervous in investing in the banks because it's still not clear how big a role the government is going to be taking." In the end, some of the weaker banks may have to turn to the government for help.

Another option for those weaker banks is to sell assets. Some analysts, for instance, are suggesting that BofA could sell Columbia Asset management and First Republic regional bank as well as its remaining stake in China Construction Bank. "Getting smaller is typically a strategy you pursue when you have to raise your [capital]," adds O'Hara.

In the end, the stress test results amount to a "technical bank regulatory matter," in Shuster's words, that allow the regulators to show the market that the banks have consistent standards for reserves across the industry. Once the confidence is created around their compliance, the theory goes, banks will be able to get back to the business of prudent lending and investors will buy their stocks.

Building Confidence

"This is great that we have a baseline, and the debate will rage on because we are talking about assumptions about the future," says Shane McGriff, vice-president for enterprise risk services at the consultancy CapGemini. "If the purpose is to have greater clarity and confidence and to better prepare for the future, then the only way for the Fed and Treasury to do that is to roll up their sleeves and look at these portfolio and shock them under some of these scenarios. Ultimately, the outcome should be renewed confidence."

Of course, the other message behind the government's stress tests is that until now banks have not been nearly diligent enough with their own internal stress-testing initiatives. Bank industry observers hope this new system becomes a habit within all banks.

"Stress testing is a remedy because it forces you out of normal business conditions and makes you look at what would happen if business changes in an adverse way," says McGriff. "I would suggest that stress testing hasn't been uniform and hasn't been routinely implemented. There's miles and miles to go before banks have invested adequately to do rigorous, ongoing stress testing."

Says financial institutions law expert James Wheeler, a partner at international law firm Bryan Cave: "What the regulators are doing here is prodding banks to find tender spots theyre not willing to find themselves." Wheeler also expects federal regulators, who already maintain a presence in all banks, to announce a broader and deeper stress test program that probes regional and community banks. "The reports released on Thursday on the 19 national banks will give the 8,500 other smaller banks a model for best practices and a heads-up on what to expect when regulators come calling for them," he says.

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