Stressing over the "Stress Tests"

As bank investors await the results of the U.S. Treasury's

As bank investors await the results of the U.S. Treasury’s “stress tests” of the nation’s largest banks, this May 4 advice from Stifel Nicolaus (SF) analyst Christopher Mutascio seems valuable:

We could try and guess what the results of the stress test will be, but that seems risky to us given that the government has been all over the map during the financial crisis. We have seen many prognostications in recent days from some that believe specific banks need tens of billions in additional capital while others believe the stress test will be rather benign. In reality, no one knows and making bold predictions ahead of the results could make one look rather foolish.

It turns out that these stress tests are not just a symbolic move by the government. These tests decide which banks will be forced to raise more capital — and by how much. Raising capital will mean issuing more shares, a step that could massively dilute current shareholders’ stakes. Without knowing how many shares will be trading, it’s impossible to do something as simple as estimate future earnings.

But the results of stress tests don’t just matter for the top 19 banks. While market observers fret over Bank of America (BAC), Citigroup (C) and Wells Fargo (WFC), it’s worth considering the next step for the U.S. Treasury. How will the government handle credit problems at smaller, regional banks?

As Mutascio implies, predicting the government’s next move may be as difficult as predicting the stress test results.

Bank analysts at Keefe, Bruyette & Woods (KBW) did conduct their own bank stress tests. They also tried to figure how much capital the entire U.S. banking system will need to survive a worst-case scenario. Their answer: An extra $1 trillion could be needed.

First quarter results at smaller banks were mixed. A KBW analysis of the 142 banks it covers showed 76, or 54%, missed Wall Street analysts’ earnings expectations. However, that’s better than last quarter, when 73% missed, or a year ago, when 66% disappointed.

On May 4, Standard & Poor’s Ratings Services placed 23 financial institutions of various sizes on “CreditWatch with negative implications,” meaning they have at least a 50% chance of seeing their credit rating lowered in the next 90 days. S&P added:

That said, we believe that most rated institutions will be able to earn their way out of these credit losses during the cycle.

The first quarter’s mediocre bank earnings (bad, but not as bad as feared) could be a tentative, positive sign that many banks can handle a tough recession. Or this could be calm period before even bigger losses hit bank balance sheets later this year.

One area of concern is commercial real estate and other commercial loans. KBW looks at 38 banks that provided data on commercial real estate loans: The non-performing ratio on those loans moved from 1.58% in the fourth quarter of 2008 to 4.36% in the first quarter of 2009. That’s quite a jump, and quite troubling.

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