- The Washington Times - Wednesday, May 6, 2009

The government’s stress tests for banks, while aimed at shoring up public confidence, have turned into what some investors are calling an exercise in smoke and mirrors.

The tests are not stressful enough, these investors say. The 19 large banks targeted by Treasury were subjected to worst-case scenarios in which unemployment rises to a 9 percent rate this year from 8.5 percent today - but many economists say 10 percent or higher is a more realistic scenario.

“The federal bank stress tests are inadequate and misleading,” said Martin D. Weiss, founder of Weiss Research, an investment research group. “The overwhelming majority of the 19 banking institutions are at risk of failure or borderline, and very few are currently strong enough to weather a worst-case scenario” envisioned by investors outside of Washington, who think the unemployment rate could go as high as 12 percent.

Wall Street titan Morgan Stanley and CreditSights, an investor research firm that has conducted its own stress tests on banks, also say the government is assuming a milder economic downturn than is likely to occur.

“The stress test run by regulators seems to be less severe than our test,” which conservatively assumes that unemployment will rise and the economy will shrink much like it does under the government’s supposedly worst-case scenario, said CreditSights analyst David Hendler.

“They may be too soft on the banks,” he said. “The bottom line is that credit is bad and will continue to get worse before it gets better.”

The stress test results scheduled for release on Thursday are expected to require about 10 banks with assets of more than $100 billion to raise more money to ward off mounting losses from defaulting loans. But Mr. Weiss pointed to several developments that suggest banks already are going through more severe stress than the Federal Reserve has projected. At the top of the list is the bankruptcy plan of Chrysler LLC, which sticks major banks such as JPMorgan Chase and Citigroup with 70 percent losses on nearly $7 billion in loans.

Mass layoffs at Chrysler and General Motors Corp. will increase unemployment, which has jumped to 8.5 percent from as low as 5 percent last year and could be only a few months away from breaching 10 percent, economists say. Defaults on credit card debt, a major income source for banks, tend to rise in tandem with unemployment.

Meanwhile, house prices continue to fall at a 19 percent rate, worsening the morass of mortgage defaults already deluging banks. But defaults are escalating not only on home loans as people lose jobs and income, but also on commercial real estate loans that are bread-and-butter income for a majority of banks.

“We have multiple confirmations that banks are indeed suffering more severe stress” than the government has even imagined, Mr. Weiss said.

Comptroller of the Currency John Dugan defended the stress tests at a Reuters conference last week. “It was never deemed to be a worst-case scenario,” he said. “It was an adverse scenario.”

Regulators also have emphasized that, whatever the economy does, they will require banks to bolster their capital by substantially more than regulations require to ensure they can weather hard times.

Mr. Weiss is projecting that 15 of the 19 banks would fail a more stringent stress test.

Even under a milder scenario, CreditSights predicts that among the big banks, Wells Fargo will join Bank of America and Citigroup in needing to raise more money to offset souring loans. Among medium-sized banks, it expects more capital will be needed by PNC, SunTrust, BB&T;, Regions, Zions, U.S. Bancorp, Fifth Third, KeyCorp and Huntington.

Were the banks to have to weather an even worse economy - with unemployment rising to 12 percent - most of them would need additional cash, including models of health like JP Morgan, according to CreditSights.

The Treasury is expected to give banks six months to raise the capital on their own through private stock offerings. But Mr. Hendler said that will not be an option for most of the targeted banks.

“The capital markets are still largely closed for the banking industry,” Mr. Hendler said, adding that the only exceptions are the healthiest banks like JPMorgan Chase and Goldman Sachs. Goldman raised $5 billion through a stock offering last month with an eye toward repaying its $10 billion government capital infusion to get out from government stress tests and other mandates.

Most other banks have turned to the Treasury for capital since the fall because of their inability to raise private funds. But the government’s meddling in the affairs of banks that took taxpayer money has made it even more difficult for banks to try to tap private markets.

“After seeing the Obama administration’s helping hand at Bank of America, Citigroup, Chrysler and GM, an investor would have to be nuts to buy shares in a bank that requires more capital,” said Peter Morici, business professor at the University of Maryland. “Private investors will likely end up with Washington as a partial and dominant shareholder too.”

Yet after six months of doling out cash to hundreds of banks, the Treasury has limited resources to bolster those that remain troubled. The Treasury’s bailout fund has dwindled to about $110 billion, and part of that is expected to go toward the expensive endeavor of sponsoring the bankruptcy of Chrysler and possibly GM.

Treasury has several tactics it can employ to try to stretch its cash. Merging or closing some of the most troubled banks remains an option.

Also, Treasury is expected to use a controversial tactic it employed with Citigroup earlier this year, when it authorized the bank to convert the preferred shares given to Treasury last fall - which pay 8 percent interest to the taxpayers each year - into common stock that does not bear interest. While that move bolsters the kind of capital that investors prefer, it also poses the danger of “creeping nationalization” of the banks as the government’s ownership share increases.

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