The Bank Stress Tests: A $75 Billion Mid-Term Exam


The Bank Stress Tests: A $75 Billion Mid-Term Exam

Federal Reserve chairman Ben Bernanke, speaking via satellite to a bank
conference sponsored by the Chicago Federal Reserve Bank, said on Thursday
morning that the stress tests ‘will allow, I hope, for greater confidence in
the banks.’ But even though the stress tests are over, the banks and their
investors are not out of the woods.

The biggest issue left unresolved by the stress tests, which concluded that 10 of the 19 top U.S. banks need an additional $75 billion in capital, is how the banks will
get de-stressed. Originally, when Treasury Secretary Timothy Geithnerannounced the tests, he said they would determine how much additional capital
banks needed to remain solvent, and the government would then provide that
amount to the banks. Now the Treasury is giving the banks that are believed
to need additional money, including Bank of America, Citigroup and Wells
Fargo, until June 8 to come up with their own plan to fix their financial
problems.
That means the banks face another test just one month from now. It’s similar
to the strategy the government took with the automakers, which were also
asked to present a recovery plan before receiving new government funds. So,
just like the automakers, expect some big changes at the banks over the next
month. Top executives of Bank of America, Citigroup or Wells Fargo could be
out of a job. The government may also decide it wants a much bigger stake
in the banks than some are currently letting on. Maybe Tim Geithner and Ben
Bernanke are better at tying up loose ends than Steve Rattner and the
Automotive Task Force, but odds are there more chapters to come in the big
bank crisis.
Of course, the government is hoping that the stress tests will be the
beginning of the end of the bank crisis because they will raise confidence
in these institutions and even give bank stocks a boost. As news of the
results has trickled out in recent days, bank stocks have indeed shot
higher as investor fear has subsided. But longer term a big issue remains:
Investors need to know just what the government’s stakes in these banks are
worth since that directly affects what the investors’ stake is worth. The
government says the future stakes it takes in the banks will not be common
equity, but preferred stock that is convertible into common equity — though
it may or may not be converted.
That raises a question for investors. If the government buys the bank’s
common stock outright, investors know how much their own stake is
diluted. But since some of the preferreds may convert and others won’t,
investors are left with a less clear picture of a bank stock’s worth.

In the end, the stress tests may do most for depositors, letting them know
that their financial institutions are either in good shape or being
repaired. That may allow the government to start rolling back some of extra
safety nets it has set up over the past year. So even though the stress
tests may not be a boon for investors, they are still a positive
development.
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