Fed Asks 10 Banks to Raise $75 Billion

123jump.com Staff
07 May, 2009
New York City

The results of stress tests released this evening may not quiet the debate about the methods of tests and if banks are adequately capitalized. The regulators asked ten of the nineteen banks to raise $75 billion by November and indicated that most banks are healthy to withstand adverse economy.

[R]10:45 PM Washington, D.C. ¨C The results of stress tests released this evening may not quiet the debate about the methods of tests and if banks are adequately capitalized. The regulators asked ten of the nineteen banks to raise $75 billion by November. Regulators also indicated that most banks are healthy enough to withstand stressful economic conditions for the next two years.[/R]

Federal regulators charged with the task of assessing health of the 19 largest banks ordered 10 banks to raise $74.6 billon and estimated losses of $599.2 billion for the period between now and the end of 2010.

The tests, two-year-ahead and two ¡®what if¡¯ scenarios were designed to include current economic scenario and adverse economic development that included weaker housing and job markets and lower valuation of assets held.

The Fed and regulators stressed that the tests by design are more stringent than solvency test and the foundation of the assumptions included financial and economic conditions similar to the ones during the Great Depression in 1930s.

The tests assumed in the worst-case scenario of 22% decline in housing prices by the end of 2010, economic contraction of 3.3% and peak unemployment rate of 10.3%. The test also assumes gradual recovery in 2010 and beyond.

123jump.com has long argued that the stress tests may be sound in their assumptions in peak measures but it is the protracted nature of the decline in key economic measures that may prove these tests inadequate. The permitted leverage in the banking sector is the root cause of the current crisis and the tests do not address them adequately.

Test Results

Bank of America was asked to raise $33.9 billion, Wells Fargo $13.7 billion, GMAC LLC $11.5 billion, Citigroup $5.5 billion, Regions Financial $2.5 billion, Sun Trust $2.2 billion, KeyCorp and Morgan Stanley $1.8 billion each, Fifth Third Bank $1.1 billion and PNC $600 million.

Nine banks that did not need additional capital buffer include; American Express, BB&T, Bank of New York Mellon, Capital One, Goldman Sachs, JP Morgan, Met Life, State Street and USB.

The Fed and regulators had guarded the identities of 19 banks till today and the list of banks includes only one foreign bank, UBS which is already operating under the protection of the Swiss government.

It is not clear why the list of banks undergoing stress test does not include financial division of General Electric and few more insurance companies.

Test Methods

The much of the controversy is surrounded with the methods of tests. The critics charge that economic scenarios considered in the tests are not stressful enough, but the tests do provide first uniform look at the nation¡¯s largest financial institutions. The 19 banks collectively hold half the deposits and two-third assets in the financial system.

The tests counted $835 billion in Tier 1 capital at these banks at the end of fourth quarter 2008 and after taking into account losses, revenues and required reserves, these firms need to add $185 billion to capital buffers.

But all of these capital has to be required at nine of the nineteen firms only and the other ten were deemed to have adequate capital in excess of 6% Tier 1 capital and 4% Tier 1 common equity capital.

The 19 banks had risk weighted asset of $7.8 trillion and Tier 1 capital of $836.7 billion and Tier 1 Common Capital of $412.5 billion.

The regulators also deemed that vast majority of shortfall of $185 billion could be withstood by the Tier 1 common equity capital with no loss in Tier 1 capital.

The statement released by Fed noted, ¡®This result means that while nearly all the firms have sufficient Tier 1 capital to absorb the unusually high losses of the more adverse scenario and still end 2010 with a Tier 1 risk©ased ratio in excess of 6 percent, 10 of these firms had capital structures that are too strongly tilted toward capital other than common equity.¡¯

Were Stress Tests Stressful Enough?

How stressful is it when the government permits Tier 1 common equity ratio of 4% that is equivalent of 25 to 1 leverage. Was it not that only a year ago that most regulators were touting a leverage of less than 12?

Also the loss estimates in commercial real estate and consumer loans sectors may not be high enough as the two segments have only now begun to face difficulties.

The test results show that if the economy were to track the more adverse scenario, losses at 19 bank holding corporations during 2009 and 2010 could be $600 billion and nearly 70% or $455 billion could stem from residential mortgages and consumer including credit card loans. Another $135 billion of losses were estimated from trading related exposures and securities held in investment portfolios.

The estimate of loan losses for two-year rate at 19 banks is 9.1%, higher than during the peak loss years of the 1930s.

The banks were tested for their adequacies of Tier 1 Common Capital but all banks were deemed to have adequate Tier 1 capital. The leverage of 25 to 1 does not inspire much confidence in these tests.

Treasury Approach

The 19 firms have U.S. Treasury preferred equity securities of $216 billion after the former Treasury Secretary Henry Paulson acted in a hurry to distribute capital.

The current banking system is still struggling with poor decision made by Paulson that distributed capital to banks with no strings attached and did not punish any bank. In fact he went on to say in his testimony to the U.S. Congress that Treasury may not have to distribute any capital to banks and if were to be distributed the U.S. will earn good return on it.

However, six months after he made these pronouncements, most banks are struggling and Fed and the U.S. will be fortunate to receive even $50 billion back in less than a year.

In fact the leadership at 19 banks before and after the crisis is same and the wisdom of lending vast sums of money to them is still questioned today.

Treasury Secretary Timothy F. Geithner can only hope that the U.S. can recover the money distributed under TARP and other programs and noted that stress tests will allow banks to raise more capital and, ¡°That will make it easier for banks to be in a position to ultimately repay the government.¡±

The reality is that the Treasury and U.S. Congress may not have more capital for banks and private sources may be the only option available to banks.

The Treasury and the Fed may have been too lenient with banks and in a joint statement they highlighted the right to replace bank leaders and boards who rely on the government for additional capital, but stopped short of asking any bank chief or board to step aside.

What About Other Banks?

The stress tests at 19 banks that are too big to fail may be welcome by the market but they represent only small fraction of 8,000 banks. The other banks hold half the nation¡¯s deposits and may have far more difficult time in raising capital.

Already banking analysts are suggesting that mid-level banks like Fifth Third, Huntington Bancshares Inc, Marshall & Ilsley and Regions Financial may have tough time raising capital in the current market conditions.

There are hundreds of community and local banks that do not have access to deep pockets or the backing of the political establishment to provide emergency capital.