Stress Test Losers: BofA, Wells Fargo, GMAC

Ten big U.S. banks must raise $75 billion in capital according to the results of the federal government's "stress tests," but banking regulators declared nearly all of the country's 19 biggest financial institutions generally healthy.

Banks needing to raise funds have a month to give regulators a "credible" plan for doing so, and six months to raise the money, with the government standing ready to make up any shortfall, officials said on May 7. Heavy reliance on the government to provide funds could dilute existing shareholders and leave the Treasury holding a substantial stake in banks, something it has said it would like to avoid.

Late Thursday afternoon several banks were already scrambling to raise capital, with Wells Fargo (WFC) announcing that it will seek to sell $6 billion in shares and Morgan Stanley (MS) saying it will try to raise $2 billion by selling stock and $3 billion by selling bonds.

The banks' capital was measured against two scenarios: a "baseline" assumption that the recession continues along the consensus estimates of economists, and a "more adverse" set of circumstances that assumes deeper and more protracted unemployment, credit problems, and so on, through the end of next year.

The bank that fared worst in the test, by far, was Bank of America (BAC), which regulators said would have to come up with $33.9 billion within six months to stand up to the "more adverse" conditions. Next were Wells Fargo, told to raise $13.7 billion, and GMAC, the big auto-finance operation, at $11.5 billion. Other banks on the list include Citigroup (C) at $5.5 billion, Regions Financial (RF) at $2.5 billion, SunTrust (STI) at $2.2 billion, KeyCorp (KEY) and Morgan Stanley at $1.8 billion each, Fifth Third (FITB) at $1.1 billion, and PNC (PNC) at $600 million.

Already Digested by the Market

However, the hit to BofA and other banks was telegraphed in leaks starting last weekend, and the stock market had largely absorbed the news and decided the test results didn't pose big new threats. BofA's shares climbed 6.5% on Apr. 7, to 13.51, a day after it rose 17%.

Federal Reserve Chairman Ben Bernanke and other officials emphasized that the one-off tests "were not tests of solvency" and that even those institutions needing to raise money were in sound condition by standard regulatory measures. Rather, the tests were designed to ensure that banks have enough capital on hand to absorb losses and leave banks in a strong financial position even if economic conditions get markedly worse.

Officials said that in most cases banks don't need more capital so much as better capital. In regulators' eyes, some types of funding are better than others, with retained earnings and common equity—the sort raised by selling common shares to the public—best of all because they come with no strings. But some large banks have become overly dependent on preferred equity and other kinds of capital that come with an obligation to pay hefty dividends or repay the investment under various conditions—limitations that may leave banks less able to absorb credit losses or other shocks, and which have exacerbated some investors' concerns about the banks' continued solvency in recent months. That less desirable capital also includes funds from the government's purchase of preferred shares starting late last year.

Regulators are encouraging banks to raise new capital by selling shares in public markets or to other private-sector investors. Banks could also sell "noncore" operating units or persuade private-sector investors to convert existing debt or preferred shares to common shares. As a last resort, the government could convert preferred shares it owns in the banks to common stock or even make new investments in the banks, buying an unusual new kind of preferred shares that would in effect convert to common stock if the banks' regulators decide it is necessary.

Will Taxpayers Be Tapped Again?

"Our sense is, these banks are reasonably confident that they're going to be able to meet these incremental capital needs from private sources," Treasury Secretary Timothy Geithner told reporters in a briefing shortly before the Federal Reserve report was released.

The government applied the stress tests to the 19 banks with more than $100 billion in assets, which together hold about two-thirds of the assets and about half the loans of the entire U.S. banking system. More than 150 accountants, economists, and others at bank regulatory agencies took part, Bernanke said. He said they don't intend to repeat the stress tests or apply them to smaller banks.

The tests have come under criticism in some quarters for taking too optimistic a view of the economic downturn, even in the worst of two hypothetical scenarios used by regulators, and for promising to stand behind banks that fared poorly, essentially guaranteeing none would flunk. But Geithner defended the tests as "very credible, carefully designed," and said they used conservative assumptions about bank earnings and revenue prospects.

Hanging over the exercise in the two months since it was announced is a politically contentious question: Will the Treasury have to seek more money from Congress to support the banks? Most of the $700 billion authorized last fall to stabilize the financial system has been committed. Congress is in no mood to grant more because of public outrage over the cost of the bailout, financial firms' compensation practices, and other issues.

Healthy Banks Can Return Bailout Cash

But Geithner said he doesn't anticipate needing more money, even if banks are unable to raise the capital they need without government assistance. "We believe we can meet the incremental capital needs identified through this assessment within the resource envelope we have," Geithner said. If necessary, however, he said he will seek additional funds.

One thing that could ease Treasury's need for more funds: have some of the healthier banks return federal bailout money to the government. Several, including Goldman Sachs (GS) and JPMorgan Chase (JPM)—which were identified in the stress tests as not needing additional capital—have said they would like to return funds received from the government last fall. Doing so would make the funds available to bolster other institutions.

Geithner said Goldman, JPMorgan, and others can return funds provided their regulators believe it won't weaken them—and if the banks can show an ability to raise a "material" amount of debt with a five-year maturity and without a federal guarantee. Since late last year banks have been able to fall back on a Federal Deposit Insurance Corp. guarantee for bonds of up to three years, substantially lowering their cost of borrowing.

In contrast, banks that need substantial additional funds from the federal government could face a management shakeup, Geithner said: "We would at that point evaluate whether management [is] strong enough to lead the institution to a point where it could be viable." Still, he reiterated the government's interest in "getting out" of its bank investments as soon as possible.

Stress Test: The Bottom Line
Company SCAP Buffer (additional capital needed)
American Express (AXP) No need
Bank of America (BAC) $33.9 billion
BB&T (BBT) No need
Bank of New York Mellon (BK) No need
Capital One Financial (COF) No need
Citigroup (C) $5.5 billion
Fifth Third Bancorp (FITB) $1.1 billion
GMAC $11.5 billion
Goldman Sachs (GS) No need
JPMorgan Chase (JPM) No need
KeyCorp (KEY) $1.8 billion
MetLife (MET) No need
Morgan Stanley (MS) $1.8 billion
PNC Financial Services (PNC) $0.6 billion
Regions Financial (RF) $2.5 billion
State Street (STT) No need
SunTrust Banks (STI) $2.2 billion
U.S. Bancorp (USB) No need
Wells Fargo (WFC) $13.7 billion
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