Published March 2, 2009

Washington's stress test for banks strains investors

By ANDREW MARKS
NEW YORK CORRESPONDENT

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DESPITE repeated reassurances that bank nationalisation is the last thing the US government wants, and that the priority is keeping banks in the hands of the private sector, Wall Street is growing increasingly worried that not many of the banks will remain healthy enough to endure rising loan losses and swooning share prices without some sort of government intervention that will likely dilute current shareholders.

Indeed, the process was set in motion last Wednesday when the Treasury Department announced that regulators had begun a stress test to determine whether the banks' already riddled balance sheets and reduced capital reserves can hold up in the face of rapidly deteriorating economic conditions. The stress test will be completed by the end of April.

If banking regulators conclude that a bank does not have enough capital under those circumstances, the bank would have to raise the extra money within six months or get it from the government, in exchange for a potentially big ownership stake.

While the Treasury Department has issued guidelines under which the 19 US banks with more than US$100 billion in assets will be analysed to weather the storm, Wall Street's bank and stock analysts are already running their own stress tests for publicly traded banks as investors worry that a government takeover could wipe out shareholder equity.

Banking analysts at Citigroup - itself the subject of government intervention - believe that the government will ultimately apply the stress test to many more banks. It recently changed its investment ratings on several regional banks after applying its own version of the stress test, upgrading three banks and downgrading three others based on metrics like relative capital strength, loan loss severity and geographic location of each bank's loans.

'At this moment, all the signals we've been getting are basically telling us that the common stock of banks is incredibly vulnerable,' says Emily Sanders, CEO of Sanders Financial Management. 'Until the government actions are determined - and I'm not even talking about nationalisation, just really solvency issues and the result of the stress tests - I wouldn't touch them with a 10-foot pole.'

But many other investment managers see opportunity in buying into relatively healthy banks whose share prices are being treated with the same contempt being heaped on the likes of Citigroup and Bank of America.

'It doesn't make sense to throw them all out when some are in far better shape than others,' said Adam Lester, a bank analyst at Equity Capital Research.

But how to determine the banks that are likely to emerge relatively unscathed and those that will require more government equity to stave off bankruptcy or an outright government takeover by the FDIC (which has already declared 39 financial institutions insolvent since January 2008) is a question giving analysts fits.

The KBW Bank Index fell 8.73 per cent last Friday after the government said it would take a large stake in Citigroup's common shares. The move, which could dilute existing shareholders' ownership by 74 per cent, fanned fears of similar actions for other major banks.

'That's the fundamental problem right now,' said Mark Specker, head of the property research group at Thomson Reuters. 'Investors are interested in getting information about loan losses and exposures, which is unobtainable now. So you've got a lot of suspicion and fear that there's still a significant amount of unexposed counterparty risk in the system. The disclosure rules around banks haven't caught up to what investors want to see,' he said.

Looking at traditional metrics, like Tier One capital ratios and loan loss provisions, does not provide a sufficient picture of a bank's health evaluation in an environment of rapidly deteriorating economic conditions, which presage far larger loan losses, analysts said.

Last week, for example, Moody's Investors Service announced it was reviewing an additional US$303 billion in commercial mortgage-backed securities, the first step in downgrading them.

'You look at Citi's risk-adjusted Tier One capital - it's up to 14 per cent. The common wisdom is that if you're higher than 8 per cent, you're well capitalised,' observed Jeff Middleswart, president of Behind the Numbers. 'They and a lot of other banks have enough credit now, but the question is how rapidly do these assets deteriorate and how much that's off their balance sheets.'

Indeed, Goldman Sachs in a research report called the coming loan losses for the large banks 'the biggest unknown, and far more important than trying to reconcile tangible equity ratios'.

Goldman favours regional banks over the big 'money centre' institutions, noting that the average large- cap bank has 39 per cent of its loans in commercial real estate and consumer loans versus just 25 per cent for regional banks. 'Critically, losses appear to grow exponentially when home price declines exceed 15 per cent - which we expect on a national basis in 2009,' the report noted.

Lacking crucial information that would offer a fuller picture of the banks' loan portfolios, investors are favouring banks like JPMorgan Chase that show strength across many traditional metrics, while betting heavily against those like Bank of America that appear weak in many areas.

Bank of America comes in at the bottom of the money centre banks with a 7.6 per cent risk-adjusted Tier One capital ratio, while JPMorgan Chase, at 8.9 per cent, had the highest, according to Thomson Reuters Fundamentals.