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Bank Tests Yield Early Progress
Firms Race to Shore Up Books

By Binyamin Appelbaum
Washington Post Staff Writer
Wednesday, May 6, 2009

The Obama administration's plan to "stress-test" 19 large banks is yielding benefits even before the findings are released tomorrow.

The announcement of the tests in February roiled the markets initially. But the 12-week wait for results has since provided a respite, allowing investors to breathe deeply and giving time for a raft of federal rescue programs to start showing results.

The banks, eager to demonstrate that they don't need more federal aid, have spent the time racing to get stronger. The healthiest banks, such as Goldman Sachs and J.P. Morgan Chase, have tried to show that they can walk without government crutches, for example by issuing debt without federal assistance. Weaker banks such as Citigroup have agreed to sell valuable business units and moved with greater urgency to offload troubled assets.

The main purpose of the stress tests remains largely unfulfilled. Federal officials want banks to raise more capital, from the government if necessary, so that they will have the financial strength to increase lending and help lift the economy from recession. The success of that process, which begins tomorrow and could take six months, ultimately will depend in large part on whether investors believe the government's assertion that many banks are healthy and deserving candidates for new investment. Otherwise, investors might not provide the needed capital.

But in persuading investors to wait patiently for the results, the Obama administration has already succeeded in achieving a goal that largely eluded its predecessor.

"The administration gets full credit for designing and communicating that there would be a new mechanism to determine needs across the system. This was a sophisticated way to establish a timetable that was readily understandable to the market," said David Nason, a Treasury aide in the Bush administration who now works for Promontory Financial.

The seeds of the stress test were planted in the fall, after Henry M. Paulson Jr., then Treasury secretary, forced nine of the largest banks to accept investments totaling $125 billion. This first round of money was intended to stabilize the financial system, but Treasury officials recognized that some of those banks would need more money. The idea of conducting a special examination to determine the needs of each bank emerged as a logical approach, participants recalled.

The deteriorating condition of Citigroup, however, forced the government to act before a plan was complete. A second ad hoc rescue soon followed, for Bank of America, further frustrating senior officials such as Sheila C. Bair, chairman of the Federal Deposit Insurance Corp., who pushed for the development of a standardized approach.

The major innovation introduced in February by Treasury Secretary Timothy F. Geithner was the emphasis on measuring all of the major banks against common standards, leveling out differences in the way firms projected losses.

At the time, the Treasury did not plan to disclose the results to the public, adhering to the long-standing practice of banking regulators that such information is kept secret to preserve confidence in banks and keep information from rivals.

But senior officials said it became clear that investors would dismiss the stress tests unless the government provided data to back its assertions about which banks were healthy and which needed additional capital. The government now plans to release about 150 pages of detailed findings tomorrow, an unprecedented portrait of the nation's largest banks.

Many financial analysts regard this transparency as one of the virtues of the stress tests because it allows investors to differentiate among banks, encouraging renewed investment in the strongest firms.

The government has tried to manage public expectations about the tests by arguing that the banks will be fine while acknowledging that they have big problems. Financial analysts said the government's efforts have calmed the markets.

Bank of America's share price has climbed by 129 percent since the tests were launched. Wells Fargo is up 78 percent, even though both companies are likely to be ordered by the government to raise additional capital. Even Citigroup, the most troubled of the large banks, has risen 27 percent.

"I think the stress test itself really spooked the system, and I think the government did a lot of damage control over the stress tests to kind of tell people that it's going to be okay," said Paul Miller, a financial analyst with FBR Capital Markets.

Miller said recent events have helped the government's case, as the largest banks posted strong first-quarter earnings goosed by a combination of diminished competition on Wall Street and the flow of cheap loans from the Federal Reserve.

Still, Miller cautioned that the stress-test process may not be enough to repair problems at the weakest firms. Senior administration officials said all 19 tested banks probably could survive the downturn without more capital by cutting back on lending and hoarding their resources. By forcing the banks to accept more capital, the government hopes to convince them that they are safe in increasing lending. The point of the stress tests is not to rescue banks from failure, they said. It is to rescue the economy.

The government hopes the new capital will come mostly from private investors. But many banks are likely to receive additional support from the government. The Treasury has allowed banks to exchange common shares for the government's preferred shares, eliminating required dividend payments.

Banks that do not require additional capital are likely to push for permission to repay the government's existing investments.

The government has allowed 11 smaller banks to repay the money, but it has not yet allowed any larger banks to do so. Some government officials said banks should not be allowed to repay the Treasury while continuing to tap other sources of aid, such as a Federal Deposit Insurance Corp. program that allows banks to issue debt at lower interest rates by guaranteeing repayment.

A senior government official said Monday that companies would be allowed to repay federal investments only once they demonstrate an ability to issue debt outside the shelter of the FDIC's program. The government plans to impose other conditions on repayment, as well, the official said. The Treasury may announce the details as early as today.

J.P. Morgan, Goldman Sachs and BB&T have successfully issued debt in recent weeks without a government guarantee.

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