The $1 Trillion Question

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The results of the “stress tests”—the parameters for which came out on Apr. 24—may not be all that terrible when the government finally releases them in early May. But many of the zombie banks will likely need to raise more money, as much as $1 trillion altogether. With the U.S. bailout funds almost gone, banks will have to convince private investors to pony up the money. That will be a hard sell.

The government first laid out a plan in late February to test the nation’s 19 largest banks. They were designed to determine whether the financial companies had enough money to keep lending in case of a severe recession. Basically, regulators wanted to figure out if the banks would survive should the economy really took a nose dive.

After initially deciding to keep their full findings private, federal officials are now releasing the details of those stress tests, if somewhat slowly. For weeks, the U.S. has indicated that the banks got passing grades—but it didn’t say which institutions passed with flying colors or just barely passed. On Apr. 24 the government outlined the methodology from those stress tests, with the results to follow on May 4.

The government has been putting banks through their paces. How so? The stress tests measure how the banks will perform if unemployment rises to between 8.8% and 10.3% in 2010; the economy grows by 2.1% and 0.5%; and home prices drop by 4% to 7%. To determine a bank’s capital needs, regulators looked at a host of different measures, including Tier 1 capital.

“Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized,” the Federal Reserve said in its Apr. 24 white paper on the methodology behind the stress test. “However, losses associated with the deepening recession and financial market turmoil have substantially reduced the capital of some banks…supervisors believe it prudent for large bank holding companies to hold additional capital.”

There’s little doubt the government will say banks need to raise more capital when officials finally release the individual report cards. What’s unknown is just how much money they need and where they’ll get it from. A recent report from the International Monetary Fund estimates the U.S. banks will need another $275 billion to $500 billion. Analyst Frederick Cannon of investment bank Keefe, Bruyette, & Woods figures the industry may need as much as $1 trillion.

The government, say some analysts, have to be cautiously optimistic—putting increasing pressure on the banks to raise money. Otherwise, investors may fear the government isn’t being upfront with them.

“[The 19 bank] have substantial earnings capacity to sufficiently withstand any reasonable short-term scenario,” says John Douglas, chair of the banking and institutions group at international law firm Paul Hastings and former general counsel for banking regulator, Federal Deposit Insurance Corp. “The government has such a credibility problem that when they say everything is a-ok, the market is going to go nuts because they won’t believe them.”

Where will the banks go for the extra capital?

The government doesn’t have much money left in its coffers earmarked for banks. There’s only about $110 billion left in the Trouble Assets Relief Program, the rescue fund used to inject money into the banks. The government expects banks to repay some $25 billion in the coming months—bringing the grand total to $135 billion.

“Markets would have to judge whether the gap could be bridged by private capital or some accounting shifts within TARP,” analyst Tom Gallagher of International Strategy & Investments said in a recent report.

There’s not much political appetite to funnel more money to the banks. That means most banks will have to raise capital from private investors, who have been petrified to plow money into the troubled industry during the financial crisis. Goldman Sachs, which is pushing to repay its $10 billion government loan, just managed to raise $5 billion in a new stock offering. JPMorgan Chase, which bolstered its books in the latest quarter, issued $3 billion in non-government backed bonds—the first such deal in roughly eight months. (Congressman Barney Frank said on Apr. 24 that Goldman and JPMorgan should be able to pay back that money.)

“We believe [JPMorgan Chase] will not require government capital and could raise the capital efficiently in the private markets and repay TARP,” says KBW’s Cannon in an Apr. 23 report.

But those relatively strong banks may be the exceptions. More troubled companies like Citigroup and Bank of America, may find it difficult to sign up outside investors. Unless they can find private money, such banks will likely have to beg the government for another handout. Most likely, that would mean converting the government’s preferred shares to common equity—thereby raising an important measure of capital called tangible common equity. Citigroup is already undergoing that conversion process.

With Mara Der Hovanesian

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