Stress Test Results Are in and They Ain’t Pretty

by Inya Ivkovic, MA

Since the credit crisis first hit the fan, last week was the first time an actual number was stuck to it, quantifying just how bad things could get for the financial industry if it dives into a deep recession. The stress test results are in: the federal government’s study has determined that 10 out of 19 banks tested came up short, needing about $75.0 billion in fresh capital. If nothing else, this study should give investors what they’ve never had before — the knowledge of which emperor has no clothes!

For the nine strong banks, including JPMorgan Chase & Co. (JPM/NYSE), State Street Corporation (STT/NYSE) and Goldman Sachs (GS/NYSE), this is an important confirmation that they can be trusted, that they can meet their financial obligations, and that they can free themselves from Washington’s not-so-subtle and certainly not gentle embrace. Knowing that, these nine banks could perhaps start lending more easily again, sending much-needed healthy capital into the financial system.

And as for the remaining 10, if they can’t find $75.0 billion on their own, which wouldn’t come as a surprise to anyone anymore, rest easy, because Washington promised to give them what stressed banks need to help the financial industry keep afloat…but with strings attached.

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What did Obama’s administration want to know? The administration wanted to test 19 top U.S. banks with more than $2.0 trillion in total assets and find out how they would fare if the economic environment worsened in the next 12 months. By “worsening economic environment,” the government assumed a 3.3% decline in GDP, an unemployment rate of 10.3%, and a 22% decline in house prices. Some thought this was too optimistic, some thought this was too pessimistic. Regardless, the government’s worst-case scenario came up with all of the banks losing in aggregate $600 billion in 2009 and 2010 and needing a total of $75.0 billion in additional capital to break even at the minimum.

One interesting thing came out of the stress test and that was Obama’s readiness to acknowledge the difference between the “haves” and the “have-nots.” This is was something that policymakers were previously very careful to avoid during a crisis. It started with Bush administration, when the Troubled Asset Relief Program (TARP) was first introduced. Under TARP, all major banks were required to take government money whether they needed it or not. The government reasoned that it truly feared there would be bank runs on some of the weaker players.

The $75.0-billion question now is: how are the 10 weaker banks going to deal with their capital deficiencies? If nothing else, needing more capital may embed them even more firmly into Washington’s grip. As it turned out, Bank of America Corporation (BAC/NYSE) is the neediest among the test 19 banks and must dig up a whopping $34.0 billion in new capital from somewhere in order to prepare for the worst. To do that, Bank of America may have to convert some of its preferred shares into common shares, with the government potentially ending up as its largest shareholder.

Wells Fargo & Company (WFC/NYSE) is next on the list, needing $13.7 billion in new capital. The company has announced that it will try to sell $6.0 billion of its shares. Meanwhile, Citigroup Inc. (C/NYSE) is dealing with a shortfall of $5.5 billion. Citigroup has been relying heavily on government help, and it also promised to convert preferred shares into common shares to bridge that shortfall.

But at least Bank of America, Wells Fargo and Citigroup have options, albeit they’re not all that pleasant. The future of GMAC LLC (GOM/NYSE), on the other hand, is much gloomier. This is the financing company at the epicenter of the government’s efforts to save General Motors Corporation (GM/NYSE). GMAC needs $11.5 billion and it has absolutely no idea how to raise it.