The results of the government’s bank stress tests won’t be released until 5 p.m. today, but people familiar with the tests and banks involved have already leaked some of the results.

The U.S. Federal Reserve has directed at least seven banks to raise more than $65 billion in capital, according to a report by the Wall Street Journal.

Bank of America Corp. (NYSE: BAC) faces a $34 billion shortfall, the largest among the 19 banks tested. Wells Fargo & Co. (NYSE: WFC) must raise $15 billion; GMAC LLC (NYSE: GMA), $11.5 billion; Citigroup Inc.(NYSE: C), $5 billion; and Morgan Stanley (NYSE: MS), $1.5 billion, the Journal reported.

J.P. Morgan Chase & Co. (NYSE: JPM), Goldman Sachs Group Inc. (NYSE: GS), MetLife Inc. (NYSE: MET), American Express Co. (NYSE: AXP), Bank of New York Mellon Corp. (NYSE: BK) BB&T Corp. (NYSE: BBT) and Capital One Financial Corp. (NYSE: COF) are in the clear in terms of having adequate capital cushioning, according to Bloomberg News.

Results for Fifth Third Bancorp (NASDAQ: FITB), KeyCorp (NYSE: KEY), PNC Financial Services (NYSE: PNC), Regions Financial Corp. (NYSE: RF), State Street Corp. (NYSE: STT), SunTrust Banks Inc. (NYSE: STI), U.S. Bancorp (NYSE: USB) are not yet available.

The banks will have until June 8 to develop a plan to raise the required capital and face a Nov. 9 deadline to implement it. They may choose to raise the funds in a variety of different ways. They may sell assets, court private investment, or convert the government’s existing preferred shares into common stock.

Citigroup has already announced plans to convert a portion of the government’s $45 billion stake to common stock, a move that will give the federal government a 36% stake in the company. Other banks regional banks such as Fifth Third or Regions Financial could be forced to take similar action, but are loath to do so, as it would dilute the value of their common stock.

Citigroup has agreed to sell Nikko Cordial Securities to Sumitomo Mitsui Financial Group (OTC: SMFJY) for about $5.5 billion. The deal, which is to be completed by Oct. 1, and is expected to boost the bank’s Tier-1 capital ratio by approximately 27 basis points.

Morgan Stanley plans to close its capital gap by selling assets or stock to private investors, a person briefed on the plan told The New York Times.

While Bank of America has said it doesn’t agree with the Fed’s conclusions, the bank yesterday outlined its strategy to accommodate the government’s demands. BofA is exploring the sale of business units such as First Republic and asset manager Columbia Management, the Journal reported.

The sale of those businesses could raise a combined $4 billion David Hendler of CreditSights Inc. told the Journal. BofA could also get about $8 billion for its partial stake in China Construction Bank Corp.

Beyond that, BofA would have the options of converting the government’s existing $45 billion investment or $33 billion in private preferred shares to common stock.

News and Related Story Links:

• Wall Street Journal:
  Banks Need at Least $65 Billion in Capital

• Bloomberg:
  Bank of America Leads List of U.S. Banks Needing Capital: Table

• Money Morning:
  Bank Stress Tests Turn Up 10 Banks That Need More Capital

• Money Morning:
  Motivations Abound for Federal Reserve’s Delayed Release of Bank Stress Test Results

• Money Morning:
  Money Morning’s Bank Stress Test Says These Three Banks Are the Strongest

• Money Morning:
  Bank of America, Citigroup Told to Boost Capital as Validity of Bank Stress Tests Is Called Into Question

Auto and mortgage lender GMAC LLC (NYSE: GKM) reported a first-quarter loss of $675 million and now faces further pressure from bank “stress tests” and freefalling sales volumes that may push its former parent General Motors Corp. (NYSE: GM) into bankruptcy. 

GMAC is one of the 19 lenders waiting for results of the government’s “stress test,” designed to determine which firms need additional capital to weather a deep recession. Results are due Thursday, and some analysts believe GMAC will be one of the banks ordered to find more capital within six months.

Despite receiving a $6 billion government bailout in December, GMAC reported net losses increased to $675 million from $589 million a year earlier, as the Detroit-based company set aside 78% more for loan losses than a year earlier.

“The effects of a soft economy and weaker credit performance on legacy assets continued to put pressure on GMAC’s financial performance,” Chief Executive Officer Alvaro de Molina said in a statement.

GMAC’s auto finance business notched a profit of $225 million, while the mortgage division, which includes Residential Capital LLC (ResCap), lost $125 million. An earlier gain of $900 million was wiped off the books after the company eliminated mortgage debt and revalued some assets.

The first-quarter loss makes six losses out of the last seven quarters for GMAC. The company had reported five straight losses before breaking the string in the fourth quarter of 2008 on gains from a debt swap.

When GMAC became a bank holding company in December in order to tap federal bailout funds, Cerberus Capital Management LP was forced to relinquish most of its 51% controlling interest. GM, which owned 49% of the lender before the bailout, is also giving up its stake and putting it in a trust.

GMAC agreed to provide financing for Chrysler customers and dealers after the automaker filed for bankruptcy protection last week. GMAC is the main provider of financing to buyers of GM vehicles. Cerberus led a buyout of Chrysler in 2007.

In a press briefing on the day of the Chrysler bankruptcy filing, a White House official said GMAC would receive the “financial support necessary” to expand after agreeing to handle Chrysler’s new loans.

Nevertheless, GMAC “faces challenges if GM files for bankruptcy,” Gimme Credit LLC analyst Kathleen Shanley wrote in a May 1 report to investors, according to Bloomberg News.  And while the Chrysler deal presents few risks for GMAC, she recommends selling the company’s bonds.

The company’s bonds rallied this year after the government said GMAC’s auto financing arm is critical to the survival of GM and Chrysler. GMAC said today (Tuesday) in a presentation on its Web site that a GM bankruptcy wouldn’t trigger its own filing.

But Pete Hastings, a fixed-income analyst at Morgan Keegan & Co. in Memphis, Tenn., told Bloomberg that a potential GM filing is a concern because it would have a “depressing effect on revenues.”

“The end markets are still troubled and the economy is still tough,” Hastings said.

GMAC said in April it would resume making car and truck loans to subprime borrowers to boost sales at GM, and that ResCap was hiring 1,000 people to handle a surge in refinancings and jumbo loans.

But GMAC has also said substantial doubt remains about ResCap’s ability to continue operating, citing deteriorating credit and mortgage markets, liquidity and capital.

News and Related Story Links:

• Bloomberg:
  GMAC Reports $675 Million Loss as Loan Defaults Rise

• Money Morning News Analysis:
  Market Moves Will Remain on Hold Until Bank Stress Test Results Are Released Thursday

The U.S. Federal Reserve today (Tuesday) delivered the results of its bank stress tests to the 19 participating financial institutions. The government will tell 10 of the banks to raise more capital, according to media reports. 

The results of the tests won’t be released until Thursday, but Bank of America Corp. (NYSE: BAC), Citigroup Inc. (NYSE: C), and Wells Fargo & Co. (NYSE: WFC) are among the institutions expected to be facing capital shortfalls.

Money Morning last month reported that Bank of America and Citigroup were told by federal regulators to raise more capital after the government’s stress tests revealed that the banks were not adequately protected against additional deterioration in the economy.

The number of institutions requiring more capital rose from six to eight when regulators boosted their target reserve requirement a week ago, according to Bloomberg. Since then people familiar with the matter, have said 10 of the 19 banks will be directed to raise capital, Bloomberg and the Wall Street Journal both reported.

Fed officials have reportedly raised the required amount of tangible common equity to about 4% of a bank’s assets, up from the 3% mark established early in the process.

Banks that fail to meet government standards will have six months to raise the required capital. They will be able to do so by selling assets, drumming up private capital, or by converting the government’s existing preferred shares into common stock.

Converting preferred shares into common equity would diliute the value of common shares, but that would be preferable to seeking more funds from the Troubled Asset Relief Program (TARP), which would almost certainly come under the condition of more executive firings and pay restrictions.

The Treasury has about $110 billion in TARP funding left to offer, Bloomberg reported.

Banks were given preliminary results of the stress tests last month, and the final results were originally scheduled for release Monday, but the Fed postponed their release after several banks objected to the findings.

Citigroup, for instance, argued that regulators hadn’t given the bank enough credit for its efforts to offload several of its smaller units, including Smith Barney and Nikko Cordial Securities, its Japanese brokerage arm.

On Friday, Citigroup agreed to sell Nikko Cordial Securities to Sumitomo Mitsui Financial Group (OTC: SMFJY) for about $5.5 billion. The deal, which is to be completed by Oct. 1, also includes a transfer of about $2 billion in excess cash from Nikko Cordial to Citigroup.  

The deal will boost the bank’s Tier-1 capital ratio by approximately 27 basis points.

Citi also has expressed frustration with the investigation into its finances.

Executives who met with regulators at the New York Federal Reserve headquarters when the banks were first made aware that they would be asked to raise more capital, say they still don’t understand the government’s methodology.

News and Related Story Links:

• Money Morning:
  Money Morning’s Bank Stress Test Says These Three Banks Are the Strongest

• Money Morning:
  Motivations Abound for Federal Reserve’s Delayed Release of Bank Stress Test Results

• Bloomberg:
  Fed Stress Tests to Show About 10 Banks Need Capital

• Wall Street Journal:
  More Banks Will Need Capital

The results of the bank stress tests are in, but instead of releasing them today (Monday), the U.S. Federal Reserve is holding them close to its chest until after the markets close Thursday.

The amount of information awaiting disclosure seems to have grown, as have the reasons to postpone the potentially damaging data.

Not only will the government unveil which banks require more capital, it will also disclose potential loss estimates for certain loan categories and the banks’ ability to “absorb those losses” assuming economic conditions worsen through 2010, a government official told The Wall Street Journal.

Negative results could deal a huge blow to both the banks and government, as a sub-par grade may be viewed as an indictment not only of the failed management of the banks, but the government’s decision to loan them billions of taxpayer money. The banks also are concerned that anything but a tactful release of the results will cause internal and investor panic.

Government and banking industry officials told Bloomberg that both sides needed the extra time to debate preliminary results, as well as plans regarding how banks can recover capital.

On April 24, the government showed the tests’ preliminary results to the 19 U.S. firms it reviewed – from behemoth banks like Bank of America Corp. (NYSE: BAC) and Citigroup Inc. (NYSE: C) to the smaller GMAC LLC (NYSE: GMA) and MetLife Inc. (NYSE: MET). The banks involved in the stress tests hold more than half the loans in the U.S. banking system and two-thirds of the assets. 

“Everybody understands they’ve got a tiger by the tail here,” Mark Tenhundfeld, a senior vice president at the American Bankers’ Association in Washington, told Bloomberg. “If they don’t let him go gently, there will be a lot of mauling going on.”

Already, reports have leaked that two specific banks need more capital, and reaction hasn’t been pleasant.

After showing Bank of America and Citigroup test results, the government told the banks to raise more capital despite receiving a combined total of $95 billion in bailout loans.

At least three more banks need more capital, either from converting common shares to equity and/or receiving more government cash, sources told Bloomberg.

Sensing blowback from Congress, as well as the public, Federal Reserve chairman Ben S. Bernanke said that banks requiring more capital will have to attempt to raise it on their own before receiving another lifeline loan from the government.

Confusion On Evaluation’s Methodology

Debate over the results isn’t the only reason for the postponement. Disputes and confusion over the Fed’s methodology has also erupted.

According to a Fed’s test criterion, common shareholder equity should be the “dominant” portion of Tier 1 capital. Officials favor tangible common equity of about 4% of a bank’s assets and Tier 1 capital worth hovering around 6%.

But The Wall Street Journal reported last week that some bank executives got mixed signals during a meeting with regulators.

The regulators are asking “a million questions” and it’s “very unclear what they’re aiming at,” a senior executive told The Journal. “We can’t discern a pattern.”

Citigroup officials argued that regulators haven’t given the bank enough credit for its efforts to offload large asset chunks, such as Smith Barney and its Japanese brokerage arm Nikko Cordial Securities.

On Friday, Citigroup agreed to sell Nikko Cordial Securities, its Japanese brokerage arm to Sumitomo Mitsui Financial Group (OTC: SMFJY) for about $5.5 billion. The deal, which is to be completed by Oct. 1, also includes a transfer of about $2 billion in excess cash from Nikko Cordial to Citigroup.  

The deal will boost the bank’s Tier-1 capital ratio by approximately 27 basis points.

Individual Result Releases

One insider told Reuters that the government is leaning toward releasing individual results for each bank involved in the stress test – a move away from issuing a summary of results.

The source said the plan “is not very far along,” and that regulators also aim to disclose a lot of confidential supervisory information about the banks.

One analyst says that test results could be so specific to a bank’s portfolio that it’s not wise to use them as a litmus test for the overall health of the banking sector.

“Once you try to take that information and extrapolate it, it gets very complicated and it’s dangerous," Kevin Petrasic, who served at the Office of Thrift Supervision from 1989 to 2008 and is now an attorney at law firm Paul Hastings in Washington, told Reuters.

Whatever the results – or how they are disclosed – Money Morning’s Shah Gilani, a former Wall Street hedge fund manager, said the evaluation process has several flaws.

“What’s missing, unfortunately, is an assumption of how much additional capital would be necessary to facilitate credit expansion – which, in turn, would serve to fuel economic growth. That, after all, should be the ultimate stress-test objective,” he wrote.

And the end result is more stress added to an already stressed banking sector, as too much information and/or misinformation only makes a sound assessment more difficult.

Money Morning’s Stress Test

The government’s pushback of stress test results only made the public more hungry for the their release. But you don’t have to wait until Thursday to know which of the 13 biggest U.S. banks are diamonds or duds.

Last week in “Money Morning’s Bank Stress Test,” Martin Hutchinson highlighted the four secrets that will let you separate the winners from the losers in the U.S. banking system

• Banks that made profits in the very difficult fourth quarter of 2008 and first quarter of 2009 are probably in good shape, especially if their loan-loss provisions exceeded their charge-offs (the amount actually lost.)
• Banks that lost money in the fourth quarter and first quarter may or may not be in terminal trouble; it depends on the amount of those losses and whether the red ink is expected to continue to flow going forward.
• With the run-up in bank stocks in recent weeks, there’s been an accompanying rise in the ratio of share price to book value (stock price per share/book value per share). If that ratio is still below 30% – even after the recent price increases – the market lacks confidence in the bank’s ability to solve its own problems. Unfortunately, the market currently appears to be overly optimistic about some of the banks that still have considerable ongoing problems.
• Management’s dividend policy is less of an indicator than it was just a few short months ago; several banks have sharply cut their dividends in order to repay the Troubled Assets Relief Program (TARP) capital they got in late 2008. Reasonably, profitable banks don’t want the government meddling in their business or compensation structures

Hutchinson also gave an individual analysis of each bank, highlighting their strengths and pulling a curtain on their weaknesses. 

News and Related Story Links:

• The Wall Street Journal:
  U.S. to Release Stress-Test Results on May 7
• Bloomberg:
  U.S. Bank Stress Test Results Delayed as Conclusions Debated
• Money Morning:
  Bank of America’s Lewis Says Paulson, Bernanke Forced Merrill Takeover.
• Reuters:
  Individual "stress tests" may be unveiled
• Money Morning:
  Controversial Stress Tests Reveal Only One Bank Needs Capital, but Worries Remain.
• Money Morning:
  Money Morning’s Bank Stress Test Says These Three Banks Are the Strongest

Barring some dramatic – and unforeseen – news this week, expect investors to tread water until Thursday, when the government is expected to release the results of the bank stress tests it conducted on the 19 largest U.S. banks.

The stress-test results are expected to show that the 19 banks may have to raise between $100 billion to $150 billion – or even more – in new capital. Investors will cause the shares of the strong players to zoom northward, and will likely savage the shares of the weakest players.

"I can’t think of a time since I’ve been watching banks when there’s been so much uncertainty about the true value of a key set of assets," Douglas Elliott, a fellow at the Brookings Institution, a Washington think tank, told Reuters.

The U.S. bank stress tests have transfixed the world financial markets for weeks, exacerbating the ongoing financial crisis – worsening the U.S. recession and shaking economies around the world. That’s escalated the burden on the still-new Barack Obama administration and on the U.S. Congress.

The banks being tested include Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC), JPMorgan Chase & Co. (NYSE: JPM), Wells Fargo & Co. (NYSE: WFC), and Goldman Sachs Group Inc. (NYSE: GS). All told, the 19 banks hold two-thirds of total U.S. bank assets.

"Most banks will have to raise capital in some form," Friedman, Billings, Ramsey Group Capital Markets Group (NYSE: FBR) managing director Paul Miller told Reuters. "The capital raises will be much bigger than people think."

Miller said that uncertainty about what the tests might reveal has made banks stocks "uninvestable" in the near term.

The issue for investors is that “you just don’t know how the government is going to view it," Miller said.

Public release of the stress test results is set for Thursday. The government is scheduled to brief the top officials of the banks themselves tomorrow (Tuesday).

Although all but one of the 19 major U.S. banks the government has stress-tested reportedly passed, many skeptics believe the banks are still using all sorts of accounting dodges to keep from revealing just much they still hold in toxic assets and bad loans, National Public Radio reported.

Why wait for the U.S. Treasury Department’s bank stress test when Money Morning can highlight the four secrets that will let you separate the winners from the losers in the U.S. banking system?
Call it the “Money Morning Bank Stress Test.”

Money Morning Contributing Editor Martin Hutchinson last week evaluated the 13 largest U.S. banks and rated them as either “Zombies,” “Walking Wounded,” “Risky But Proud,” and “Hidden Gems,” and concluded that nine of the banks pose some degree of risk. But he also found that four of the financial institutions are “Hidden Gems” that might be worth a look for investors.
On Thursday, we’ll finally see how it all plays out.

Market Matters

Chrysler LLC filed for bankruptcy and then forged a potentially “game saving” partnership with mighty Fiat SpA (OTC ADR: FIATY), Italy’s largest car manufacturer.  General Motors Corp. (NYSE: GM) will be saying good bye to its Pontiac brand (any interest, Fiat?).  Bank of America’s Ken Lewis was stripped of his board chair, but will continue to put out fires from the chief executive office.   Earnings season moved forward and Exxon-Mobil Corp. (NYSE: XOM) did NOT set a new record for a change.  International Business Machines Corp. (NYSE: IBM) bucked the cost-cutting trend and actually raised its dividend.

With Treasury set to release the stress test results on Thursday, rumors are circulating that Bank of America and Citigroup may be in need of additional capital, though both are pleading their cases.  Meanwhile, Citi began lobbying for permission to pay retention bonuses to key employees [it worked for American International Group Inc. (NYSE: AIG) and Merrill Lynch (NYSE: SQD)], who may seek the greener pastures of other (ailing) financial institutions.

Telecommunications firms were in the spotlight early in the week as chipmaker Qualcomm Inc. (Nasdaq: QCOM) raised its revenue outlook and Verizon Communications Inc. (NYSE: VZ) actually announced increased earnings in the first quarter.  Verizon may be teaming up with Microsoft Corp. (Nasdaq: MSFT) to develop its own touch-screen cell phone to cut into Apple Inc.’s (Nasdaq: AAPL) iPhone market share.

Drugmakers Pfizer Inc. (NYSE: PFE) and Bristol-Myers Squibb Co. (NYSE: BMY) posted quarterly results that beat Wall Street expectations, as did The Dow Chemical Co. (NYSE: DOW) and Starbucks Corp. (Nasdaq: SBUX), though the latter’s major restructuring (store closures) prompted a 77% decline in profits.

MasterCard Inc. (NYSE: MA) confirmed that 2009 will be a challenging year, though rival Visa Inc. (NYSE: V) beat earnings estimates, as debit card usage increased, resulting in greater fee income.

The Procter & Gamble Co. (NYSE: PG) struggled last quarter, with weaker sales, as shoppers traded down to lower-priced consumer goods.  Exxon-Mobil, Chevron Corp. (NYSE: CVX), and Royal Dutch Shell PLC (NYSE ADR: RDS.A, RDS.B) were victims of the declining global demand for oil.  Still, Exxon’s long-term outlook remains strong as the company continues pouring money into development projects to be fully prepared once the recession ends.  In fact, management even boosted its stock dividend. 

Economically Speaking

While the U.S. Federal Reserve seemed to offer some “cautious optimism” about the overall direction of the economy, the policymakers avoided any sugarcoating and hedged their comments for fear of an unforeseen development (such as the “swine flu,” also known as the A/H1N1 flu).

While the virus quickly expanded across the globe, most of the worst cases have been limited to Mexico, where the already depressed economy will be further impacted from business closures and travel restrictions.

When SARS (Severe acute respiratory syndrome) hit in 2003, China’s gross domesic product (GDP) was estimated to have been hurt by about 1%; According to early projections by Moodys Corp.’s (NYSE: MCO) Economy.com, the Mexican economy will contract by 6.2% in 2009 (revised from the -4.5% estimate to account for the flu).

The Fed plans to leave rates at near 0.0% and stands prepared to purchase more Treasury and mortgage-related securities to keep the economy moving in the right direction.

The first quarter’s gross domestic product (GDP) highlighted a relatively hectic week on the economic front.  While the economy contracted from January through March at a worst-than-expected 6.1% clip, analysts found some positives deep within the release, as consumer activity actually picked up during the quarter.

The spending component rose by 2.2%, after falling by 4.3% in the fourth quarter.  Additionally, a decline in inventories hindered the release; however, economists point out that such a reduction indicates that manufacturers have scaled back production and will not be burdened with excessive supplies that may need to be deeply discounted to be sold. As demand slowly returns, they will be able to boost production once again.

Meanwhile, consumer confidence surprisingly soared to levels not seen since November 2008, which is especially good news, since the consumer accounts for about two-thirds to 70% of the activity in the economy.   

Weekly Economic Calendar

[Editor’s Note: For more insight into the bank stress tests, check out this related story, which appears elsewhere in today’s issue of Money Morning. The report is free of charge.]

News and Related Story Links:

• NPR:
  Will Bank Stress Tests Soothe Public Fears?
• Money Morning Banking Analysis:
  
  Money Morning’s Bank Stress Test Says These Three Banks Are the Strongest.
• Money Morning News Analysis:
  U.S. Auto Industry Spins Out of Control, as Chrysler Goes Bankrupt and GM Struggles to Reverse Course.
• Guardian Unlimited:
  Spain leads Europe in swine flu cases with 40.
• Wikipedia:
  Severe acute respiratory syndrome. 
• Money Morning News Analysis:
  Data Shows Unemployment, Consumer Spending Close to Turning a Corner.

Why wait for the U.S. Treasury Department’s bank stress test when Money Morning can highlight the four secrets that will let you separate the winners from the losers in the U.S. banking system?

Call it the “Money Morning Bank Stress Test.”

Back in February, I looked at the Top 12 U.S. banks, to determine whether it was really necessary – as U.S. Treasury Secretary Timothy Geithner was proposing at the time – to devote the enormous sum of $1.5 trillion of our money to bail them out. I came to the conclusion that such a huge bailout was unnecessary, and that only a few of the Top 12 banks seemed in any danger of collapse. Fortunately, policymakers and the market have now come to agree with me.

With banks’ first-quarter figures now out, it seems a good time to take another look. Since, at reader request, I had added Fifth Third Bancorp (Nasdaq: FITB) to the Top 12 (I have written on Goldman Sachs Group Inc. (NYSE: GS) and Morgan Stanley (NYSE: MS), now technically banks, separately), meaning that we now, here, have a “Top 13″ list of banks – a bit smaller than the list of 19 the government has stress-tested.

[I'm aware of the hang-ups and superstitions involving the number "13." But I'll brave the bad luck, as I can't believe that number will stay at 13 for more than a few months; at the bottom end of the quality spectrum, there are clearly a few banks that need to be put out of their misery.]

All of the financial institutions discussed here have been subjected to Treasury Secretary Geithner’s “bank stress tests” and we are told they have all passed, with one exception (more information is due to be released Monday). That is hardly compatible with the government stance – of just two months ago – that another $1.5 trillion would be needed. I would suggest that the truth is somewhere in between the two extremes: Most of these banks are in reasonable shape and can be expected to recover on their own, but a few need to be put out of their misery.

For the U.S. Treasury Department to buy up “toxic assets” in alliance with hedge funds seems a very bad idea; these banks have been managing their toxic assets themselves and know their portfolios best. Banks that have accumulated toxic-asset portfolios too large to manage, or that are managing them ineptly, should be put out of their misery – and not rewarded with asset purchases at inflated prices. Capital needs to be invested in the most-efficiently run venture, not the least-efficiently run institution.

There is lots of information – about both the potential bailout needs and possible investment bargains – that can be gleaned from the banks’ first-quarter reports. But there are four key factors that investors can employ to separate the investment-worthy bank stocks from those that aren’t.

These four Money Morning bank-stress-test secrets will lead investors to conclude:

• Banks that made profits in the very difficult fourth quarter of 2008 and first quarter of 2009 are probably in good shape, especially if their loan-loss provisions exceeded their charge-offs (the amount actually lost.)
• Banks that lost money in the fourth quarter and first quarter may or may not be in terminal trouble; it depends on the amount of those losses and whether the red ink is expected to continue to flow going forward.
• With the run-up in bank stocks in recent weeks, there’s been an accompanying rise in the ratio of share price to book value (stock price per share/book value per share). If that ratio is still below 30% – even after the recent price increases – the market lacks confidence in the bank’s ability to solve its own problems. Unfortunately, the market currently appears to be overly optimistic about some of the banks that still have considerable ongoing problems.
• Management’s dividend policy is less of an indicator than it was just a few short months ago; several banks have sharply cut their dividends in order to repay the Troubled Assets Relief Program (TARP) capital they got in late 2008. Reasonably, profitable banks don’t want the government meddling in their business or compensation structures

Using those four Money Morning bank-stress-test indicators, we can assess the viability of the leading U.S. banks. We can then divide them into four categories, from weakest to strongest (Zombies, Walking Wounded, Risky-but-Proud, and Hidden Gems). Here are the four categories, and how we defined them:

• Zombies: Institutions kept alive only by TARP funding. These subtract value from the economy and should be put out of their misery through controlled liquidation, with the healthy parts being salvaged.
• Walking Wounded: These may well need some moderate additional help, but are operating reasonably well on their own, right now. Even so, there is a caveat: Should there be an intensification of the current U.S. economic downturn, one or more of the “Walking Wounded” could be pushed into “Zombie” status – or even bankruptcy.
• Risky-but-Proud: These banks have relatively high risks, either because of some ill advised past acquisitions, or because of their business mix. Even so, the “Risky-but-Proud” banks are operating at full blast and can hold their heads high for their success in dealing with enormous difficulties.
• Hidden Gems: These banks have conquered 2008’s difficulties, taken care of their bad-debt problems, and still managed to make a substantial profit. Short of a repeat of 1929-1933, they should continue to do so. Not all these “Gems” are still hidden, however, now that the market has experienced a substantial run-up from its bottom, with many bank stocks seeing even bigger gains.

Here are the Money Morning stress-test ratings of the 13 largest U.S. banks (by assets). The list that follows ignores foreign-owned banks, and also avoids Goldman Sachs and Morgan Stanley, for the reasons we cited earlier. We list the “Top 13″ here in reverse order (smallest banks listed first), because the status of the biggest banks is much easier to determine after you’ve studied comparable regional banks, which have simpler businesses:

13. Fifth Third Bancorp (Nasdaq: FITB). Zombie: With $120 billion in assets, and having received a $3.4 billion TARP investment, this Cincinnati-based regional bank grew by buying other banks in the Midwest and Florida. A recent share price of $3.71 meant Fifth Third was trading at 28% of book value. It lost $1.2 billion in 2008 (even after goodwill write-offs), and has lost another $26 million in the first quarter of this year – a bad result, since the 2008 disaster and the TARP investment should have allowed it to mark down its bad assets, taking “everything but the kitchen sink” into the 2008 loss. Without further federal assistance, Fifth Third’s survival as an independent entity would seem to be extremely doubtful; an orderly liquidation would seem the best alternative. Certainly it should not be subsidized further.

12. Regions Financial Corp. (NYSE: RF). Walking Wounded: With $146 billion in assets, and a $3.5 billion TARP investment, this Birmingham-based regional bank has operations primarily in the Southeast. A recent share price of $5.56 meant Regions Financial was trading at about 30% of book value. It has cut its dividend to a nominal 1 cent per share. It lost $5.6 billion in 2008, and its tangible net worth is only $10.5 billion. However, that loss was entirely an impairment of goodwill; on an operating basis, Regions made a profit of about $300 million. It notched a $77 million profit in the first quarter, although executives stated on the conference call that its Georgia and Florida markets were still a problem. Regions is a definite “Walking Wounded” bank, and is very close to “Zombie” status. However, it’s likely to need only modest additional funding, and looks to be significantly stronger than Fifth Third.

11. BB&T Corp. (NYSE: BBT). Hidden Gem: With $152 billion in assets, and a $3.1 billion TARP investment, this Winston-Salem, N.C.-based regional bank has its primary operations in the Mid-Atlantic region. A recent share price of $23.42 meant that BB&T was trading at about 94% of book value. BB&T was profitable in each quarter of 2008 and in the first quarter of 2009, making $1.5 billion for all of last year and $271 million in first quarter of 2009. It maintained its dividend of 47 cents a share for first quarter of 2009, the only bank to maintain its full payout. The question, of course, it whether management will be tempted to follow fashion and cut the dividend next quarter; otherwise, it looks very solid.

10. Capital One Financial Corp. (NYSE: COF). Zombie (was Walking Wounded): Primarily a credit-card company with some banking operations it acquired, this McLean, Va.-based company has $161 billion in assets, and accepted a $3.6 billion TARP investment. Capital One looks to me like the credit-card-market equivalent of mortgage lender Countrywide Financial Corp. Capital One’s recent share price of $18.97 meant that Capital One was trading at 28% of book value. It lost $1.4 billion in fourth quarter of 2008, and was just below breakeven for the full year, although it reported making $895 million from continuing operations. Capital One lost $112 million in first quarter of 2009, and cut its quarterly dividend from 37.5 cents per share to 5 cents a share. If credit card losses continue to deteriorate, as seems likely, Capital One is a “Zombie,” and only a sharp improvement in the credit-card market can save it.

9. State Street Corp. (NYSE: STT). Hidden Gem: With $174 billion in assets, and a $2 billion TARP investment, this Boston-based bank is focused chiefly on serving institutional investors worldwide. Its recent share price of $37 meant that State Street was trading at 146% of book value. Its 2008 earnings per share (EPS) of $3.89 represented a year-over-year increase of 13%. First quarter net income down 16%, but State Street still earned $445 million. It pays a quarterly dividend of 24 cents per share. With a global business, conservative leverage and Boston management, State Street is a great risk. But it’s somewhat of an unexciting investment currently as securities issues and trading volume have fallen.

8. SunTrust Banks Inc. (NYSE: STI). Walking Wounded (but in danger of Zombification): With $189 billion in assets, this Atlanta-based regional bank accepted a $4.9 billion TARP investment, and has operations in the Mid-Atlantic and Southeast regions, especially Florida. With a recent share of $15.96, SunTrust was trading at 31% of book value. It posted a fourth-quarter loss of $379 million, but its overall 2008 profit was $747 million. However, SunTrust posted a first quarter loss of $815 million, including $715 million of mortgage- and real-estate-loan losses. The bank reduced its quarterly dividend sharply to 10 cents per share in fourth quarter. SunTrust saw its financial position deteriorate in the first quarter, and is in severe danger of zombification, although there are now reasons to believe most of its problems may be out in the open.http://www.google.com/finance?q=bk

7. Bank of New York Mellon Corp. (NYSE: BK). Hidden Gem: With $237 billion in assets, and a $3 billion TARP investment this New York-based bank has its primary operations in New York and Pennsylvania, and has an institutional/corporate orientation. With its recent share price of $26.88, it is trading at 122% of book value. It reported 2008 net income of $1.39 billion, and first quarter profit of $322 million, after which the bank reduced its quarterly dividend from 24 cents to 9 cents a share. Looks solid to me.

6. U.S. Bancorp (NYSE: USB). Hidden Gem: It has $266 billion in assets, and a $6.6 billion TARP investment and is a regional bank headquartered in Minneapolis that operates primarily in the Midwest and Northwest. A recent share price $18.97 means it is trading at 176% of book value. It reported a 2008 profit of $2.94 billion, and a first quarter profit of $419 million. U.S. Bancorp cut its quarterly dividend from 42.5 cents per common share to 5 cents a share, as it wants to pay back its TARP investment. This bank is in good shape, but its capital base would become too thin if it repaid TARP; I’m not sure I want to pay 11-12 times earnings for this stock when the dividend’s so low and the uncertainties are so high, as there’s still some chance of dilution, should it raise capital.

5. PNC Financial Services Group (NYSE: PNC). Risky but Proud (but close to upgrading to Hidden Gem): With $291 billion in assets, and a $7.6 billion TARP investment, this Pittsburgh-based bank bought the slightly larger Cleveland-based National City Corp. in October. Its primary operations are in the Mid-Atlantic and Midwest regions. A recent share price of $43.22 meant it was trading at 104% of book value. PNC’s net income was $882 million for 2008, and $460 million for first quarter of 2009. It cut is quarterly dividend from 66 cents per common share to 10 cents per common share. PNC appears to be handling its National City acquisition well, but remains concerned about possible deteriorations in its credit quality. Nevertheless, PNC’s problems – particularly those derived from National City’s Ohio base – are not hidden, and its continuing profitability means PNC is close to an upgrade.

4. Wells Fargo & Co. (NYSE: WFC). Risky but Proud (but close to upgrading to Hidden Gem): With $1,309 billion in assets, and a $25 billion TARP investment, this San Francisco-based bank went national with its acquisition of Wachovia Corp. With a recent share price of $21.40, this stock is trading at 123% of book value. Wells incurred a fourth-quarter loss of $2.55 billion, not including $11 billion net loss at Wachovia; full-year 2008 earnings were $2.84 billion, and first quarter 2009 earnings came in at $2.38 billion. The stock pays a quarterly dividend of 34 cents per share, but may cut the payout (though this has yet to be announced). Like PNC, Wells is fairly high risk because of the acquisition and Wachovia’s own 2006 acquisition of the California mortgage bank Golden West Financial. But Wells, also like PNC, benefits here because most of its problems are in the open. Optimism may have pushed this stock up too high in the near-term, however.

3. Citigroup Inc. (NYSE: C). Zombie: With $1.945 trillion in assets and a $45 billion TARP investment, plus government guarantees on $301 billion of its assets, this is the big fish for federal regulators. I believe it should be liquidated, though maybe the regulators they want to practice on Fifth Third, first. A global financial conglomerate based in New York, Citi has been a serial flirter with bankruptcy over the last 30 years. A recent share price of $3.19 means the bank is trading at 25% of book value; it’s the only bank stock down since my February report. Citi lost $18.7 billion in 2008. It theoretically made money in the first quarter of 2009, but lost it again because it had to reset the terms of some preferred shares issued the previous year, further diluting common shareholders. It reduced its dividend to a nominal 1 cent per share. At the annual stockholder’s meeting, Citi Chairman Richard Parsons said that “shareholders want profits or flesh, either one.” If I were a Citi shareholder, I’d want both.

2. JPMorgan Chase & Co. (NYSE: JPM). Risky but Proud (close to upgrading to Hidden Gem): With $2.175 trillion in assets, and a $25 billion TARP investment, this New York-based international bank has a large investment-banking operation and bought The Bear Stearns Cos., in March 2008 and the housing-lender Washington Mutual in September – both with federal help. With a recent share price of $33.38, JPMorgan was trading at 92% of net asset value. It had 2008 net income $5.6 billion, and made $2.1 billion in the first quarter of 2009. JPMorgan reduced its quarterly dividend of 38 cents per share to 20 cents in this year’s first quarter. Again, very high-risk because of its acquisitions, JPMorgan nevertheless appears to be in excellent shape – and like PNC and Wells Fargo, may be overcoming the problems it does have.

1. Bank of America Corp. (NYSE: BAC). Zombie: With about $2.8 trillion in assets (including Merrill Lynch & Co., which was acquired after the 2008 year-end), and a $45 billion TARP investment (plus $118 billion in asset guarantees against Merrill Lynch assets), this Charlotte, N.C.-based retail bank is a nationwide player. It bought No. 1 housing lender Countrywide Financial Corp. and No. 3 investment bank Merrill Lynch in 2008. Its recent share price of $9.10 meant it was trading at 32% of book value. BofA reported a fourth-quarter net loss of $1.55 billion, plus the Merrill Lynch net loss of $15.3 billion. It reported a first-quarter profit of $2.8 billion after preferred share dividends, but that included $2.2 mark-to-market write-up of Merrill Lynch debt (the opposite of all those “mark-to-market” write-downs that banks are whining about). It reduced its quarterly dividend to a nominal 1cent per share. Judging by other banks’ results, if Bank of America had made no acquisitions in 2008, it would be in solid shape today. However, excluding special items, it’s barely ahead of break-even in the first quarter after a horrendous 2008, and seems decidedly accident-prone. As the revelations about former Treasury Secretary Hank Paulson strong-arming BofA Chief Executive Kenneth Lewis to push through the Merrill deal seem to show, the bank’s management is pretty anti-shareholder, too.

There are two types of conclusions to be drawn from this analysis, public policy conclusions and investment conclusions.

On the public policy side, it is becoming even clearer that buying up bank “toxic assets” is a very expensive way to attack the problem. The government provides taxpayer subsidies both to hedge funds doing the buying and to banks doing the selling, most of which don’t need the money. At the same time, for the “Zombies” like Fifth Third and Citigroup, taxpayers would have to buy a huge chunk of the balance sheet before the problem was solved.

Equally, there are some banks out there that are not going to recover on their own, and it’s getting close to time for some “tough love.” There’s a public policy case for further subsidies to the borderline cases – Regions and maybe SunTrust – but there is no good case for further subsidies to Fifth Third and the egregious Citigroup, or to Bank of America. As for Capital One, if the credit card business recovers very quickly, it may survive on its own. But if the market doesn’t improve, Capital One should be liquidated, since its business model is based on aggressive card marketing and controversial fee charging – practices which should both be discouraged in a well-run financial system.

For outside observers, the best sign that the crisis is really over will be when the Feds push one or other of the Zombies over the edge. That may not be for some months yet, however.

The investment picture for banks has deteriorated in three ways since my February report:

• First, some of the borderline cases, notably SunTrust and Capital One, have slid further towards Zombie status.
• Second, several banks that were paying juicy dividends have cut them sharply, in spite of continuing to earn enough to cover them. However, since many of the nation’s bank management teams want to get out from under the TARP bonus restrictions, those cuts were decidedly anti-shareholder in nature.
• Third, stock prices have shot up – in several cases by more than 50% – even for doubtful survivors like Capital One. Investor sentiment has swung from deeply negative to rather positive on the U.S. banking system, while the sector’s overall condition has somewhat deteriorated. Stock prices well above net asset value do not adequately account for the considerable continuing risks to the U.S. banking system, or of the feeble dividends that most banks currently pay.

Of the healthier banks, I like JPMorgan Chase, because it is still trading at less than book value, even though the investment banking part of its business is intrinsically unattractive. PNC, at just above book value, is also probably worth looking at; it appears to be well run. Finally, if BB&T avoids the dividend cut frenzy, and maintains its 47-cent dividend (the announcement will be made around May 24), its 8% yield makes it attractive.

News and Related Story Links:

• Money Morning Investigative Report on the Bank Bailouts (Part VIII):
  Obama Administration Must Revive “Shadow Financial System” to Revive U.S. Banks.
• Money Morning News Analysis:
  Controversial Stress Tests Reveal Only One Bank Needs Capital, but Worries Remain.
• TimesOnline:
  More than 100 funds want to buy toxic assets.
• Investopedia:
  Loan-Loss Provisions.
• Wikinvest:
  Troubled Asset Relief Program.
• Money Morning Market Analysis:
  The Top 12 U.S. Banks: From Zombies to Hidden Gems.
• Money Morning News:
  Bank of America’s Lewis Says Paulson, Bernanke Forced Merrill Takeover.

Bank of America Corp. (BAC) and Citigroup Inc. (C) were told by federal regulators to raise more capital after government “stress tests” revealed that the banks were not adequately protected against additional deterioration in the economy, published reports said yesterday.

Officials insist that neither Bank of America nor Citigroup should be viewed as insolvent, but people familiar with the situation told The Wall Street Journal that the capital shortfall amounts to billions of dollars at BofA. It is not clear how much of a shortfall Citigroup faces.

Analysts anticipate that some regional banks also will be required to raise more capital.

Banks that need more capital will have six months to accumulate the additional infusions by selling assets, selling more shares, or converting preferred government shares into common stock. If they are unable to build their capital through public and private sectors, the banks may again dip into taxpayer-funded government coffers.

Bank of America and Citigroup have received a combined $95 billion in taxpayer infusions, as well as hundreds of billions of dollars in government guarantees on bad, or “toxic,” assets.

The government may become Citi’s largest shareholder as soon as next month when the bank converts as much as $52 billion in preferred stock into common shares.

If the banks are forced to take on more government funding, top executives at both BofA and Citi could be forced to resign. Citigroup Chief Executive Officer Vikram Pandit and the bank’s board of directors faced the ire of shareholders at the company’s annual meeting last week. But even as tensions flared, efforts to oust the management fell flat, as 10 incoming members of the company’s board, some of whom have been in place for two decades, were affirmed by shareholder votes.

Top-tier executives at Bank of America may not be so fortunate. BofA shareholders today (Wednesday) will decide the fate of Chairman and CEO Kenneth Lewis. Lewis has come under fire for the company’s acquisition of Merrill Lynch & Co. Inc. (SQD) last year. Merrill Lynch lost $15.84 billion in the fourth quarter of 2008, contributing to a $1.79 billion loss at BofA and forcing the bank to seek out more government assistance.

“The same directors and management that entered the Merrill deal are still there, and we think they destroyed shareholder value on a permanent basis,” Jon Finger, whose Houston-based investment firm is urging votes against Lewis and lead director Temple Sloan, told the Charlotte Observer.

For his part, CEO Lewis testified before New York’s attorney general that Federal Reserve Chairman Ben S. Bernanke and former Treasury Secretary Henry M. Paulson Jr. pressured him to move ahead with the merger despite his reservations – while also keeping quiet about mounting losses at the crumbling investment bank.

“I can’t recall if he said, ‘We would remove the board and management if you called it [off],’ or if he said, ‘we would do it if you intended to.’ I don’t remember which one it was,” Lewis said, referring to a conversation he had with Paulson. “I said, ‘Hank, let’s de-escalate this for a while. Let me talk to our board.’”

Bank Stress Tests Called Into Question

Both Bank of America and Citigroup objected to the preliminary findings by the government. Citi, in particular, has expressed frustration with the investigation into its finances.

The regulators are asking “a million questions” and it’s “very unclear what they’re aiming at,” a senior executive told The Journal. “We can’t discern a pattern.”

Executives who met with regulators at the New York Federal Reserve headquarters on Friday, when the banks were first made aware that they would probably be asked to raise more capital, say they still don’t understand the government’s methodology.

The Journal cited people familiar with the matter as saying Citi wants to get credit for its recent effort to unload such businesses as Smith Barney and Nikko Cordial Services, the bank’s Japanese brokerage arm. While these businesses have not yet been offloaded, they’re expected to boost Citigroup’s capital levels.

Citi also has concerns about the assumptions used by the Fed in projecting future losses and revenue.

Citigroup executives aren’t the only ones questioning the Fed’s methodology, either.

Elizabeth Warren, who chairs the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP), is just as confused as the Citigroup execs.

“I had believed that we would receive a much more detailed description of the stress tests last Friday,” Warren, who is known as the TARP watchdog, said Monday at the Reuters Global Financial Regulation Summit.

Unlike Citigroup, however, Warren said that one of her main concerns is that the stress tests being applied by regulators are not stressful enough.

Calling the adverse scenario used to test the banks’ health “disturbingly close” to current economic conditions, Warren sparked concern that a second round of tests might be needed.

“The stress tests will make a terrific contribution if they are tough and transparent,” she said. “If they are not, they will be useless.”

The fear that the stress tests are causing more harm and doing more to detract from investor confidence than to inspire it has been an underlying theme of the government plan.

Analysts speculate if government officials – under fire for not being more forthcoming about the details of their evaluations – were to release the methodology of the stress tests, analysts would compare that test criteria to public financial data and start to draw their own conclusions about which banks are likely to fail or will require additional infusions of capital.

“They’ve gotten themselves in a pickle on this thing,” Bert Ely, an independent banking analyst told The Los Angeles Times. “It’s clear they didn’t think through how this was going to play out.”

The results of the test were initially scheduled for release on Monday, but the government has since said the results will be released later in the week.

[Editor's Note: Money Morning Contributing Editor Shah Gilani, a retired hedge-fund manager and a recognized expert on the global credit crisis, says the bank stress tests are stressing out investors. To read his analysis, which appears elsewhere in today's issue of Money Morning, please click Bank Stress Test Report. The report is free of charge.]

News and Related Story Links:

• Wall Street Journal:
  Bank bailout plan’s ’stress tests’ already causing stress

• Reuters:
  TARP cop sees unstressful bank tests

• LA Times:
  Bank bailout plan’s ’stress tests’ already causing stress

• Money Morning:
  Controversial Stress Tests Reveal Only One Bank Needs Capital, but Worries Remain

• Money Morning:
  Stress Tests Put Obama Administration in “No-Win” Situation

• Money Morning:
  With Government Talking to Citi About a Larger Stake, Bank Nationalization Still Off the Table

• Money Morning:
  Bank of America’s Lewis Says Paulson, Bernanke Forced Merrill Takeover

The bank stress test of the nation’s 19-largest financial institutions is a flawed exercise that threatens to elevate the very economic-system stress it was designed to relieve.

The U.S. Treasury Department isn’t scheduled to release the results of the much-ballyhooed bank stress tests until Monday. Little has been revealed so far, but one fact seems certain: Whatever information is disclosed is likely to be either too much – or even more likely – not enough for analysts, investors and the public to determine the soundness of a banking system upon which the nation’s economic growth is predicated.


We’re already starting to see bits and pieces leak into the public domain. And the response hasn’t been positive.

Although the tests reportedly concluded that only one of the 19 banks that received a stress test would require additional capital, the government’s own bailout-fund watchdog has questioned whether it was really much of a test at all.

The reason: The “adverse scenario” used for the test was “disturbingly close” to current economic conditions, said Elizabeth Warren, the chairperson of the Congressional Oversight Panel for the Troubled Asset Relief Program, and a frequent critic of the government bailout programs.

Now the government is urging foundering giants Bank of America Corp. (BAC) and Citigroup Inc. (C) – which have already taken in a combined $95 billion in taxpayer-provided bailout money – to raise more capital [For the latest facts on these developments, check out this related bank stress test story that appears elsewhere in today's issue of Money Morning].

Flawed Assumptions Lead to Flawed Results

As outlined to the public, the stress tests were to pre-suppose a set of declining economic circumstances that would negatively impact bank balance sheets. For example, one scenario assumes that U.S. unemployment rises to 10.3% by the end of 2010. How or why the 10.3% assumption was chosen – as is the case with other scenario parameters – is unknown and is supposedly not to be revealed.

The assumption of testing through the end of 2010 means only that a two-year window was established for definitive calculations. Under this scenario, examiners assumed two-year cumulative losses of 8.5% on mortgage portfolios, 11% on home-equity lines of credit, 8% on commercial and industrial loans, 12% on commercial real estate loans, and 20% on credit card portfolios. The results are then totaled and weighed against assumptions – again unknown – about the capital positions of the banks at that time.

The fact that the assumptions themselves are a constantly moving target in our current crisis doesn’t lend comfort to any baseline conclusions that may be reached. On the other side of the equation, the tests don’t assume any revenue forecasts – either negative or positive – and may not assume further equity capital destruction or changing capital structures at the banks.

The idea is to take an expansive look at capital adequacy in the face of inherent credit risks, and exposure to off-balance-sheet liabilities, derivatives, or counterparty agreements. Once those risks are quantified, the government examiners will attempt to determine about how much capital is needed to support bank balance sheets and fluid liquidity. The net result of the tests is to identify which banks need to raise additional capital now to meet assumptions that may never happen, or may in fact be more destructive than assumed.

What’s missing, unfortunately, is an assumption of how much additional capital would be necessary to facilitate credit expansion – which, in turn, would serve to fuel economic growth. That, after all, should be the ultimate stress-test objective.

In fact, the key problem with the whole stress-test exercise is that it does nothing to improve financial-system transparency – something I’ve said would be key to a true reformulation of the U.S. banking system. As currently conceived, there will be no clear assessments possible as a result of these tests upon which private investors can rely to provide the necessary capital to make up for any shortfalls. The stress tests may, in fact, have the opposite effect – and could discourage new equity investment in any of the banks.

Where Are the “Toxic Assets” Hiding?

Whatever is revealed through the convoluted prism of the stress tests should be compared to the relatively straightforward data available from other institutions, such as the Federal Deposit Insurance Corp. (FDIC). The FDIC’s “Quarterly Banking Profile” offers a cut-and-dried summary of financial results for all FDIC-insured institutions.

According to The Financial Times‘ review of the data as of Dec. 31, loans outstanding were $7.87 trillion. The Times noted that Goldman Sachs Group Inc. (GS) economists estimate the shortfall in Tier 1 capital, given certain liberal assumptions, to be at least $753 billion.

The International Monetary Fund (IMF) has estimated that the potential losses of U.S.-originated credit assets held by banks and financial institutions around the world is $2.7 trillion, The New York Times said last week. While the percentage of those losses that sit directly on the books of U.S. banks isn’t known, it is widely assumed that the value of impaired assets exceeds $1 trillion. To further complicate and obfuscate necessary transparency, new accounting rules replace mark-to-market reality with subjective internally modeled accounting of the value of distressed assets. And until those unidentified and convolutedly accounted for assets are removed from bank balance sheets, they will weigh down the worldwide banking system for years to come.

Perhaps the greatest danger the stress tests will cause may result from seemingly healthier banks pressuring the government to take back taxpayer-funded capital, while at the same time facilitating a dangerous lopsidedness to the entire banking landscape.

The fallacy that some banks are doing well and want to pay back government money is easily pierced. Whether it’s for general liquidity, for credit spreads, or to backstop their efforts to raise additional capital, the truth is that there isn’t a single bank that isn’t currently using government support in some form. The only way to determine if a bank is healthy is to require it to stand entirely on its own and to not incorporate any cheap government capital or any government liquidity enhancing facility.

That will never happen in the current crisis. No bank is going to give up the preferential, cheaper cost of borrowed money provided by government vehicles when their competitors remain at the trough soaking up cheaper, government-backed capital resources. Until the entire system is self-sustaining, privately funded and supportable – and that distinctly assumes that some banks need to die a quick death and be buried – the system should be looked at as just that – a system.

Attempting to measure the health of every patient in the hospital by sticking a thermometer in only the sickest patients isn’t going to do anything to stem the epidemic. The Treasury Department made a fundamental mistake in offering to reveal the results of stress tests. What it should have done is conduct system-wide tests on all banks, after which it systematically merged and shut down institutions that were either desperately threatened, or downright insolvent.

Yes, equity capital would be lost. But, as a lesson in moral hazard, it would be the clearest signal possible that shareholders are responsible for controlling boards even more so than boards are responsible for controlling management and risks at corporate institutions.

Until private-equity investors are confident that the nation’s sick-and-injured banking patients are truly curable, there will be a decided reluctance to invest necessary capital into an uncertain future.

Nothing has been accomplished by these “stress” tests – except to further stress the banks, as well as the already-badly stressed U.S. economy.

News and Related Story Links:

• Money Morning Week Ahead:
  Controversial Stress Tests Reveal Only One Bank Needs Capital, but Worries Remain.

• Wikinvest:
  Troubled Asset Relief Program.

• Money Morning Commentary:
  Plan to Repair U.S. Banking System Unveiled by Former Hedge Fund Manager.

• Wikipedia:
  Tier 1 Capital.

• The New York Times:
  I.M.F. Puts Bank Losses From Global Financial Crisis at $4.1 Trillion.

Only one of the 19 financial institutions that received a bank stress test would require additional capital, the controversial government initiative has reportedly concluded.

The identity of the bank that is alleged to have failed the bank stress test was not revealed.

The bank-stress-test findings were reported yesterday (Sunday) by CNBC.com, which said it obtained the information from a source that it did not identify. The source did not identify the company, CNBC.com reported.

“At least one firm – under the [bank] stress test assumptions – will require more capital,” the source said.

The bank-stress-test results were contained in a two-dozen-page report that the government released Friday. But the results had already been “conveyed” to the firms, meaning the bank in question is aware of the U.S. central bank’s assessment, according to the published report.
                                                                     
This round of bank stress tests was essentially a two-step process. The first step – outlining how the banks have been analyzed – was taken care of with the report released over the weekend.  The second step – releasing the results to the public – will be taken care of when the actual results are released May 4, which is one week from today (Monday).

Neither the U.S. Federal Reserve nor the U.S. Treasury Department would comment.

The bank stress tests have a very specific purpose. Financial institutions that are found to have inadequate capital will have six months to raise the money via the private sector. If that doesn’t work, the government has said the financial institutions will be eligible for an infusion of capital via the federal government’s so-called “Capital Access Program.”

U.S. Treasury Secretary Timothy F. Geithner said he would be open to banks repaying their Troubled Asset Relief Program (TARP) loans, as long as the availability of credit (borrowing) was not adversely affected.  As a Money Morning special report detailed last week, the credit markets don’t seem to be loosening up: Lending dropped by more than 20% from October 2008 to February 2009, despite initiatives to encourage such activity.

According to the conclusion of the report released over the weekend, “most banks currently have capital levels well in excess of the amounts needed to be well capitalized.”

However, as Money Morning has reported, the tests have become a “no-win” situation for the Obama administration.

“There are two things that are terribly wrong,” William M. Isaac, the Secura Group chairman who served as head of the Federal Deposit Insurance Corp. (FDIC) from 1981 to 1985, told CNBC.com. The first problem – and a big one – is the fact that the details were announced at all.

“I can’t imagine what Treasury was thinking when it made that move. It has been causing incredible angst in the markets,” said Isaac. “The second big problem is that the Treasury is directing the stress testing, apparently with direct involvement of the White House at the highest levels. Bank regulation by law is supposed to be carried out by the independent banking agencies without any political interference.”

Market Matters     

As Money Morning reported Friday – in a Wall Street version of the old “he said/(s)he said” drama, Bank of America Corp. (BAC) Chairman and Chief Executive Officer Kenneth Lewis claimed that ex-U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. and central bank Chairman Ben S. Bernanke threatened to remove him from office if he backed out of the Merrill Lynch & Co. Inc. (SQD)  merger or (publicly) discussed the mounting losses.

Paulson had previously testified that Lewis must have misinterpreted their comments, but then seemed to blame Bernanke for the threat (Translation: Paulson tried to throw Bernanke “under the bus.”).

New York Attorney General Andrew M. Cuomo has been investigating the activities surrounding the merger to determine why shareholders were kept in the dark about the financial “challenges.”

Shifting to autos, Italy’s Fiat SpA (OTC ADR FIATY) emerged as a potential major global player as it attempts to forge a partnership with (soon-to-be-bankrupt?) Chrysler LLC, and also has interest in buying General Motors Corp.’s (GM) Opel unit. Meanwhile, GM will be closing 13 production plants over the summer to trim inventory and seems likely to miss a $1 billion debt payment due June 1 as it too moves closer to bankruptcy protection.

How bad is GM’s plight: GM may close its Pontiac division after 82 years of operation, The Wall Street Journal and MarketWatch.com reported over the weekend.

While the earnings news of the week found plenty of winners and losers, ultimately analysts perceived a bit of “cautious optimism.”  Bank of America and Morgan Stanley (MS) failed to live up to the favorable showings by Wells Fargo & Co. (WFC) and other financials, though techs like Texas Instruments Inc. (TXN), Apple Inc. (AAPL) and International Business Machines Corp. (IBM), beat Wall Street expectations, and brought new hope that the downturn was nearing an end. (Watch for an updated “Hot Stocks” feature on IBM here in Money Morning later this week).

Unfortunately, Microsoft Corp. (MSFT) posted the first quarterly revenue decline in its 23-year history, though investors still cheered its ability to reduce costs during these challenging times for PC sales. McDonald’s Corp. (MCD), AT&T Inc. (T), and Ford Motor Co. (F) were among the diverse group of companies reporting better-than-expected results, while United Parcel Service Inc. (UPS), Caterpillar Inc. (CAT), and Continental Airlines Inc. (CAL) issued disappointing numbers.

Amazon.com Inc. (AMZN), the subject of a recent “Buy, Sell or Hold” feature here in Money Morning, bucked the negative trend facing many retailers and posted higher quarterly earnings and revenue.

Additionally, U.S. retailers J.C. Penney Co. Inc. (JCP) and Coach Inc. (COH) each expressed positive sentiment that sales activity seems to picking up.  Oracle Corp. (ORCL) snapped up Sun Microsystems Inc. (JAVA) for $7.4 billion after IBM chose to pass, and PepsiCo Inc. (PEP) is attempting to purchase two related bottling companies as corporate execs seek favorable deals in this environment.  Such merger-and-acquisition (M&A) transactions often signal boardroom confidence and also indicate that the “worst” part of a downturn may be over. 

Oil prices surged above the $51-a-barrel level late in the week as traders overlooked the higher inventory levels and instead focused on some favorable signs that the economy may be closing in on turnaround mode.

With a six-week winning streak on the line, investors offered their best “clutch hitting” late Friday, pushing all major indexes to higher levels. Early in the week, after investors digested negative news from the likes of Bank of America and GM, prognosticators said the weekly stock-market winning streak was all but over. However, some better-than-expected earnings and economic reports brought out the “bulls” for one final run.  The Nasdaq Composite Index ended the week in positive territory, and the other equity indexes were virtually flat from last week’s closing levels (with the Dow Jones Industrial Average suffering a slight decline). 

Economically Speaking

According to the International Monetary Fund (IMF), the global downturn will be far worse than previously expected.  For 2009, the IMF expects the world economy to contract by 1.3%, its first such decline in 60-years, with over 10 million employees losing their jobs.  Unfortunately, its projections for the United States are even more dire (-2.8% for the year), with domestic financial institutions suffering $2.7 trillion in losses, almost twice the IMF’s prior estimates from just six months ago.   

While much of the economic data of the week confirmed the IMF’s weak projection, analysts found a few positive signs that the downturn very well may have bottomed out.  While both new home sales and durable goods orders declined in March, the results beat the weaker Street expectations and came in the aftermath of some (relatively) strong February numbers.

In another promising sign of stability within the housing sector, the median price of an existing home sold in March actually rose for the second straight month.  Still, the record unemployment filings last week revealed the ongoing difficulties facing job seekers amid these tight labor conditions.  Likewise, leading economic indicators, a predictive report, dropped for the third consecutive month and many economists expect the recession to last at least until late third quarter. 

Weekly Economic Calendar

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The Obama administration may have backed itself into a corner when it released the details of the "stress test" methodology being used to evaluate the health of the nation’s big banks. 

With final results not expected to be released until May 4, releasing the testing methods for Citigroup Inc. (C), JPMorgan Chase & Co. (JPM), Bank of America Corp. (BAC), and 16 other banks is only likely to increase market speculation – the exact result Obama’s economic team is trying to avoid.

Releasing the formula may also lead analysts to compare the test criteria to public financial data and start to draw their own conclusions about which banks are likely to fail or will require massive infusions of additional capital.

"They’ve gotten themselves in a pickle on this thing," said Bert Ely, an independent banking analyst. "It’s clear they didn’t think through how this was going to play out."
The stress tests are based on two scenarios: One assumes current forecasts for the recession are correct and that the unemployment rate will remain at 8.8%, while the other projects conditions will deteriorate with unemployment climbing as high as 10.3%, according to documents released by the U.S. Federal Reserve.  The tests are being used to determine if banks have enough money reserved to withstand further losses under either scenario.

The administration has said no banks will fail the test, but if they fall short, regulators will force them to boost their capital. If they can’t raise the funds through private sources in six months, the government will step in with funds to shore up operations at the banks that are deemed too big to fail.

Part of the tests will focus on loan quality as a measure of health. Commercial loans in default or foreclosure soared to $65.9 billion in the first quarter, up 43% from $46 billion at year-end, according to New York-based research firm Real Capital Analytics Inc. Property values have fallen at least 30% since their 2007 peak.
U.S. banks have reported more than $550 billion in writedowns, losses and credit provisions since 2007, according to Bloomberg data. Banks have raised more than $400 billion from private investors and the government to guard against loan losses as mortgage defaults surged.

Federal Reserve officials disseminated preliminary results to representatives of the banks on Friday.   KBW Inc. (KBW) issued a report on April 23 that said lenders may need to raise $1 trillion in capital to cushion losses.

The fear is that speculation will only increase after the release of the testing criteria, which may cause a run on banks with capital needs.  That could make it harder for them to persuade investors to give them cash.

"We’re really hesitant to put money into financials," Douglas Ciocca, a managing director at Renaissance Financial Corp. in Leawood, Kansas, told Bloomberg News. 

"The ambiguity is still engulfing the opportunity."

Regulatory bank reviews are normally kept secret to avoid shaking up investors and customers who may race to withdraw their money.  The administration is trying to  maintain a delicate balance between revealing too much – which could destabilize weaker banks – or saying too little, leading the public to assume the government is whitewashing the results. 

The tests are at the center of the Obama administration’s plan to stabilize the financial system. Officials have been refusing to answer questions about the banking system for months saying they’re awaiting the test results.

Officials are trying to release enough information to give investors confidence. But they don’t want to give analysts so much detail that they can run their own tests on the banks before the official release of results.

The slow-motion rollout is intended to tame market reaction to the news but that might backfire as well.

"It’s a week plus until we find out, that’s where the danger is," said Anton Schutz, president of Mendon Capital Advisors Corp. in Rochester, New York, which manages $150 million of financial stocks, told Bloomberg. "You get market movement on what might be fact or fiction," he said.

Further complications may arise when the government releases final results on May 4 because the Obama administration may ask banks that need more capital to disclose how they plan to get additional funds.

In a report on the tests last week titled "Total Confusion," analyst Richard X. Bove of Rochdale Securities contended that the government is in a no-win situation because there was "no effective way to communicate the results of this test without causing greater stress than the test itself," the Times reported.

News and Related Story Links:

• Los Angeles Times:
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