Published May 8, 2009

Stress tests bring relief in their wake

Some US banks need more capital but it is far less than feared, reports say

By CONRAD TAN

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(SINGAPORE) Financial markets yesterday cheered the news that the biggest banks in the United States face smaller capital shortfalls than originally feared, and that the gaps may be plugged without wiping out existing shareholders.

Early reports suggested that the 19 largest US financial institutions that were subjected to 'stress tests' administered by the US Treasury and the Federal Reserve would need to boost their capital levels by far less than the hundreds of billions of dollars initially thought.

The results of the stress tests - widely leaked but officially to be revealed at 5pm yesterday in New York - are expected to show that about 10 of them need more capital to keep lending and withstand further losses if the recession is worse than expected.

Bank of America (BOA), expected to need the biggest capital boost, may need to raise some US$34 billion, reports said.

Citigroup is expected to need more than US$50 billion, but most of that will be raised from the conversion of preferred shares to ordinary equity and asset sales that are already in progress. That leaves a gap of at most US$6 billion that it will need to fill, a Financial Times report said, citing people close to the situation.

At least five other financial institutions will need to boost their core equity capital levels, including Wells Fargo, one of the largest US commercial banks; GMAC, the financial arm of ailing carmaker General Motors; and Morgan Stanley, the Wall Street Journal reported, citing people familiar with the matter.

In total, the seven banks have been told to boost their equity capital levels by some US$67 billion.

At least seven others - Goldman Sachs, JPMorgan Chase, American Express, Bank of New York Mellon, Capital One Financial, MetLife and BB&T - have passed the test without needing to raise new capital, a Bloomberg report said.

Equity indices in Asia and Europe surged yesterday, amid relief that the US government is unlikely to end up holding controlling stakes in the biggest US banks.

The relief was due not just to the reports that the capital shortfalls were smaller than expected, but also the repeated statements by the US government and bank officials that the banks have several options to boost their ordinary equity capital levels without taking more cash from the public purse or ceding a large stake to the government.

'We don't want to create a situation where the government has to come in, except where that's necessary,' Timothy Geithner, the US Treasury Secretary, said in a television interview on Wednesday.

The banks could sell some assets to raise cash, as BOA and Citi are already attempting to do. Some, including BOA and Citi, could also persuade existing private-sector preferred shareholders to convert their holdings into ordinary stock to improve the quality of their capital base. That would reduce the banks' need for new funds, but would dilute existing ordinary shareholders.

They could also issue new mandatory convertible preferred shares to the government that would dilute existing shareholders only when converted to ordinary shares in future; the hope is that the banks would be able to repay the government before conversion is necessary.

Still, some critics have questioned the very credibility of the tests, suggesting that the assumptions used weren't demanding enough, making the results unreliable.

Nouriel Roubini, chairman of consulting firm RGE Monitor and a professor of economics at New York University, said that 'the stress tests' conclusions are too optimistic about the banks' absolute health', arguing that the worst-case economic scenario envisioned by authorities had already been surpassed by actual developments in recent months.

Kevin Scully, who heads independent equity research firm NetResearch Asia here, said that the assumptions used would determine how convincing the conclusions of the tests are. 'The key now is what kind of default rates these banks will see on their loans in the coming months.'

But Mr Geithner said that regulators had applied 'exacting estimates' of potential losses over two years and 'conservative estimates' of potential earnings, before comparing them with the banks' existing reserves and capital.

'The results were then evaluated against strict minimum capital standards,' he wrote in a contributed article to the New York Times yesterday.