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Government Reveals Results of Bank Stress Tests

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Binyamin Appelbaum
Washington Post Staff Writer
Friday, May 8, 2009; 11:00 AM

Post staff writer Binyamin Appelbaum discussed the health of the 19 largest U.S. banks, after government stress tests determined that 10 of them needed an infusion of capital to survive the recession.

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NYC: Dr. Doom and others have been very critical of the stress test and its data. Are their arguments valid? I have a sense that what was done was better then not testing and perhaps less good then really putting some serious butt kicking data into the test. Is some data better then none?

Binyamin Appelbaum: We won't know which projections about the economic future are right until we get there. Dr. Doom could well be right. The virtue of the stress tests, at least in theory, is that it should now be possible to determine how much money the banks would lose under any economic scenario. If an investor thinks Dr. Doom is correct, they can draw conclusions accordingly.

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South Riding, Va.: I know that the government said that several of the banks included in the stress test need to raise more capital. Is this just based on the current economics or would they need to raise more capital in a normal economy to maintain the requirements for FDIC insurance or other banking requirements?

Binyamin Appelbaum: Good question. The government applied two separate tests. Under the prevailing rules, all banks are required to hold $6 in capital for every $100 in loans and other assets. That's what you're referring to as the normal requirements, and by that standard all but two banks are fine -- GMAC and Regions Financial.

The government also applied a special standard, requiring banks to hold a second buffer, a subset of the first buffer, of $4 in common equity for every $100 in assets. To be clear, the $4 is a subset of the $6, not additional money. Common equity is capital raised from selling common shares or retaining profits. It's considered more dependable than other forms of capital.

This is the test that 10 of the banks failed, so they need to raise more common equity, either by converting other forms of capital, or by selling more shares.

Does that make sense?

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Kent, Wash.: I've gathered from the newly released stress test results that most of our banks need to raise capital. Is there anything that can be done to get them to start selling some of the distressed properties that most seem to be hell bent on holding on to? In my town last week there were 530 distressed listings on our MLS (bank owned, short, foreclosure) out of a total of 706 listings. That's over 75%. Yet if an agent can find a buyer that can actually get a loan, most of the homes available require lien-holder approval and guess what -- they aren't giving it. So the properties just sit and buyers wait until they can't wait anymore. We all know that most homes are undervalued just as they were overvalued 5 years ago, but isn't 50-75% of something better than 100% of nothing? Shouldn't banks get back to lending and get out of the real estate business? Wouldn't that raise capital and also increase prices and value?

Binyamin Appelbaum: Officials hope that the results will encourage banks to start selling troubled assets including foreclosed homes.

The logic goes like this: The banks now need to find private investors (to avoid taking money from the government). Those investors want to put money in banks that are in good shape. So the banks have an incentive to clean house, so to speak.

We'll see if it works.

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Rural Virginia: Instances of corruption and incompetence fill the news. I have the impression that the SEC is trying to parse policy from personnel in order to isolate the problems.

Do you sense that the final outcome will be one in which there will be a round of M&A activity in banking, followed by new regulations that will limit bank charters to basic checking and savings services? Will banks be forced out of the credit card business?

Binyamin Appelbaum: Most experts believe we will see a round of M&A, but not immediately. It's too hard right now to raise the necessary money for acquisitions.

There is some talk about restricting what banks can do, but it hasn't gained much traction.

Credit cards are a pretty basic form of banking, so I think that's unlikely to go away.

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Anonymous: Have you gotten an idea of when the federal agency that is dealing with the amount of capital the banks are supposed to have is going to let them pay the U.S. government back? Don't you think it might be a good idea to actually let those financial institutions pay on their "bailouts" and thusly instill in people who voted for the current administration confidence in their good choice? Are some or any changes in the regulations in place that would decrease some of the over leveraging that is thought to have created the recent financial crisis? Thank you for taking my question.

Binyamin Appelbaum: Thanks for the questions.

The government already has allowed 12 smaller banks to pay back their capital, a little less than $2 billion in all.

As of today, the larger banks can also seek permission. They just need to show a) they have enough capital after repayment to maintain lending and b) they can sell debt without a government guarantee.

Paying back the money terminates executive compensation restrictions, so the idea is to make sure that banks don't continue to rely on the debt guarantee program, which doesn't impose any such restrictions.

Oddly, the government will let banks continue to borrow from the Fed's emergency programs, which also don't impose any restrictions.

As for leverage, regulators are talking very seriously about permanent changes that would require institutions to hold more capital, limiting leverage across the system.

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Norfolk, Va.: I believe I saw a commentator on TV this morning say that approx $90B of Bank of America's $171B of "assets" was based upon BOA's "goodwill," an entirely intangible asset. Is that assertion correct? If so, shouldn't the average person be skeptical of the results of these tests?

Binyamin Appelbaum: This is a really important point.

Banks have plenty of Tier 1 capital, a very broad measure that includes money raised in all sorts of ways, but investors no longer trust Tier 1.

So the government now is requiring banks to have plenty of a tighter measure of capital, called common equity. But as you point out, even that measure still includes about $87 billion in goodwill as of the end of March.

Goodwill works like this: You buy a company for $10, the sum of its parts is only valued at $7, you get to count $3 in "goodwill" on the grounds that the price you paid accurately reflects the value of the whole.

The idea is that you could get that money back by reselling the company. But a lot of investors think that's a dubious assumption under current market conditions.

Bottom line, in general: For this and other reasons, it will be interesting to see how seriously investors take the government's assertion that the banks are basically well-capitalized.

Are you skeptical?

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Alexandria, Va.: How were the tests conceived and conducted? Does the government regularly perform stress tests on the banking system, or is the first time something like this has been done?

Binyamin Appelbaum: Regulators regularly perform stress tests, but those tests are usually conducted on individual banks -- or even individual kinds of loans at a single bank. This test was different because it evaluated all banks using common standards.

Also, regulators generally project one year into the future. This time, two years.

Finally, the tests projected a worse economic situation than is actually expected. Generally, regulators would use a more moderate forecast.

As for the history, I wrote about it here.

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Arlington, Va.: Where can we find a list of the banks that failed? And what's next for those banks? Do we need to worry about money we might have in them?

Binyamin Appelbaum: The FDIC maintains a list here.

As for your money, almost all deposits are insured by the government, up to $250,000 per account. No one has ever lost a penny of insured deposits.

Unless you're above that threshold -- which you should not be -- no reason for concern.

(If you're a shareholder or a creditor, that's a different matter.)

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New York, N.Y.: I am trying to figure out the message here: This bank is failing so you are at risk of losing your money if you keep it in this bank, but don't take your money out of the bank as that will cause it to fail, and then the government will have to bail it out, although the government is going to bail it out, so you shouldn't have taken out your money, although the bank was going to fail, but that's because you took your money out even though we warned you to, but told you not to...

No wonder the public is confused.

Binyamin Appelbaum: See previous response: There's no reason to withdraw money from a failing bank. So much for that Gordian knot.

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Selling Distressed Properties: How are the results of the stress test going to promote the sales of additional properties? Wouldn't mark-to-market require them to write down their assets if they sold properties at cut rates, further exacerbating their liquidity problems? In short -- a loss that hasn't been realized increases their liquidity in an artificial manner.

Also, what about the commercial real estate bubble? Which banks are most exposed in that arena?

Binyamin Appelbaum: The idea is that investors would rather invest in a bank that has already recorded the loss, than in one that continues to hold the troubled asset -- better to know than to wonder.

But you're right that some banks may be constrained in their ability to sell certain troubled assets because they can't absorb the writedowns.

That's why some experts believe the government's capitalization efforts are focused in the wrong place and it would be better for the government to focus on clearing away the troubled assets.

Officials have been talking about that for more than a year now, and we still haven't seen a program, although the FDIC now says it hopes to launch a pilot in June.

We shall see.

As for the commercial real estate bubble, some of the banks with the largest exposure to commercial real estate include Regions Financial of Alabama, BB&T of North Carolina, KeyCorp of Ohio and PNC of Pennsylvania.

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Economic outlook: You note that the authorities who conducted the stress tests projected a grimmer economic outlook than we'll probably see actually ensue -- how do you think they came to their conclusion that it's going to be that bad if all other indicators suggest we'll rebound faster?

Binyamin Appelbaum: To be precise, they projected a grimmer outlook than they consider likely. A lot of people think they weren't grim enough.

That said, the point was to err on the safe side, reassuring investors that the banks could survive even a scenario worse than is likely to unfold.

(The flip side is that, in forcing banks to prepare for problems they are unlikely to face in reality, it is tying up resources that could be used for lending.)

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Rockville, Md.: Now that stress tests have been done on the nation's largest banks, will the government turn its attention to the mid-size and smaller banks? I keep my savings in a regional bank that I've always thought was a reputable institution, but now I'm starting to wonder -- I mean, if these big banks can fail, wouldn't the smaller ones be even more vulnerable?

Binyamin Appelbaum: Good question.

The government says it won't stress test any additional banks.

Some smaller banks are in much better shape, because they weren't involved in the madness of securitization.

Others, however, created their own problems through speculative real-estate lending and a general absence of prudence in lending.

And unlike the large banks, with the government has declared immune from failure, smaller banks are still allowed to fail -- and some do almost every week.

But to repeat an earlier point, if by savings you mean deposits, there's no reason to worry -- everything up to $250,000 is insured by the government.

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Falls Church, Va.: How long did it take to conduct the stress tests? What was the impetus for conducting them in the first place? And do you expect to see other sectors experiencing similar government-run stress tests?

Binyamin Appelbaum: The stress tests were announced in early February, launched in early March, and the final touches weren't finished until Tuesday. So about two months in all.

As for this history, you can read about it here.

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How much is too much?: Where is all of this capital going to come from? Taxpayers? Does the Fed have some sort of reserve that it'll use to infuse the failing banks? I guess I just keep thinking that there must be an end to this seemingly unending pot of gold that the government appears to have at its disposal. Thoughts?

Binyamin Appelbaum: There's a lot of confusion about what happened yesterday, mostly because a lot of the media did a singularly terrible job reporting on the government's announcement.

The bottom line: Banks need to raise as little as $9.5 billion, which is not a lot of money by present standards.

We've reported that about $7.5 billion will come from the Treasury Department; the rest most likely from private investors.

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Bethesda, Md.: What's next for the banks that failed? Will the government just take them over?

Binyamin Appelbaum: The banks that failed the test?

No, the government isn't taking over any of these companies.

Two of them, GMAC and Citigroup, plan to yield the government minority ownership stakes.

The rest hope to patch their capital holes with money from private investors.

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Washington, D.C.: Does the administration have a lot of credibility tied up in this? If one of these banks ends up being "sicker" than we're hearing now, it's going to cause a ripple effect, no?

Binyamin Appelbaum: Yeah, that's a very good point.

Clearly, the credibility of the stress tests depends on the government being right.

They came out and said they went and looked carefully and this is what they found.

If they're wrong about even one bank, I agree that the whole edifice will come tumbling down.

That's one reason why the government used such negative assumptions -- they can't afford to be wrong.

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So if they do fail...: What happens to the accounts people have in them? I know that the government insures them up to $250K, which is great, but what happens to the actual accounts -- do the failed banks get subsumed into healthy ones? I'm used to banks taking over other banks -- the account I opened at one bank in 1996 has gone through probably four different mergers over the past 13 years -- but it seems like in this case it'd be different because it's not necessarily a takeover or a merger. Anyway, any clarity?

Binyamin Appelbaum: Good question, and there are several possible answers.

Most failed banks are immediately sold by the government to a healthy bank. For account-holders, the process is pretty much identical to a merger, something most of us have experienced. (My childhood savings bank is now in the hands of its eighth owner.)

In rare cases -- though more often lately -- the government can't find a buyer. In some cases, the government chooses to operate the bank for a while before selling it, which again has no impact on depositors. That happened with IndyMac last year.

In some cases, the government simply closes down the bank. This is the only situation that really impacts people in your situation. If that happened, the government would give you a period of time to open an account with another bank and transfer the money there.

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Cleveland, Ohio: How often will these tests be repeated? Do you see this as an ongoing effort on the part of the government? I think it'd make more sense for them to monitor the banks on a quarterly or bi-annual basis, as opposed to annually or every other year.

Binyamin Appelbaum: The government insists these tests are a one-time event, but I think it will be interesting to see whether at least these tighter capital standards eventually are adopted and applied more broadly.

Do note that the government supervises banks continuously. At the largest banks, regulators literally work on site, in a special office provided by the company.

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Oakland, Mich.: How long did it take the government to conduct these tests? Were they politically driven at all (as in, who in Congress was pushing for them)? And who gains from the news? Must be a relief, for example, for the banks that passed the test -- will it be something you'd expect those banks to trumpet to their account holders?

Binyamin Appelbaum: Two months.

Certainly it was political. This is Washington. But it was the administration's idea, not Congress. The Obama administration saw this as a good way to show that the banks were being restored to health. And as a piece of political theater, it's working remarkably well so far, at least to judge from the stock market's reaction.

As for trumpeting the news, most definitely! The banks blessed with the federal seal of good health have been trumpeting the news quite loudly.

Here is the release from JPMorgan, to take an easy example.

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Fairfax, Va.: Bank regulators, unlike the SEC and investors, generally don't want too much transparency for fear of causing bank runs. (Try to get the troubled bank list from the SEC.)

Although deposits are protected to $250K, this is a problem for businesses, attorneys holding trust accounts and others. One doesn't have to be too large a business to have a payroll of that size. So long as there isn't full disclosure, it seems to me that there is an obligation to insure accounts totally.

As for investors, the recent experience shows that investing in a bank is really a gamble, given the black box financing involved.

Binyamin Appelbaum: FDIC announced in the fall a total guarantee on deposits that don't pay interest, which covers almost all of the small-business accounts you're describing. The guarantee is not permanent -- I think it runs until the end of the year -- but hopefully concerns will be easing by then.

As for investing in banks, lately it hasn't been much of a gamble -- more like burning money.

(Although if you bought BAC in February, you could have made a small fortune already.)

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Charlotte, N.C.: What can the banks do from here to help themselves? Or are they completely at the mercy of the government to bail them out?

Binyamin Appelbaum: Good question. Several of the banks already have said that they will try to sell common shares to private investors, so we're going to see an immediate test of whether the banks can help themselves. If they can sell shares, we're on the road to recovery. If they can't, it's back to life support.

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Blame?: Is anyone going to be held accountable for those banks that failed the tests? Or will this be another case of the Administration just blaming the economy and going in for the save? In other words, we've seen the execs of various financial institutions on Wall Street and even the car execs being called out for failing to manage their businesses well -- will we now see the execs for the failing banks testifying before Congress?

Binyamin Appelbaum: We have already seen several hearings with the executives of major banks, and I'm confident that we will see more over the coming months. The executives of collapsed companies have been particularly excoriated, but those that remain in trouble -- Citigroup and Bank of America particularly -- are likely to do their time before Congress.

That said, I'm not sure failing this test is the greatest of their sins.

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History?: Binyamin, could you give us some historical context? Have we ever seen banks this large fail at the same time? Does this portend a move from a recession into a depression? Or am I over thinking it? Thanks.

Binyamin Appelbaum: Sure, I love historical context.

There have never been bank failures on the scale we've seen over the last year. Washington Mutual was the largest bank failure in history by a very large margin, and then Wachovia -- which failed for all intents and purposes -- came along and topped it.

This is largely because banks this big are a new thing in America. We simply didn't have superbanks until various legal changes in the 1990s.

Big banks are fundamentally a creature of government. They can't grow this large organically. The business is too unstable in the long run.

But it turns out that even the government can't always keep banks this large in business.

So now we need to confront the questions of whether superbanks are good or bad for the economy.

As for what this portends, if you mean the results of the stress tests, I actually think the news is quite good. We seem to be escaping the financial crisis, which is a critical prerequisite for economic recovery.

As for overthinking, I'm all in favor.

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Wheeling, W.Va.: Was there any hesitation on the part of the administration to reveal that 10 out of the 19 largest banks (i.e. more than half) are in trouble? This just doesn't seem like good PR for either the banking industry or the administration.

Binyamin Appelbaum: Lots of hesitation, particularly among banking regulators, who are secretive by birth and breeding.

But one way to think about this announcement yesterday is that it basically took an industry that people generally regard as troubled and announced that half of these 19 banks are in excellent condition. That may actually be an improvement in the public perception.

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Vienna, Va.: So what's next? How do you see the market reacting over the coming weeks with respect to this news? And what do you think will happen to the banking industry in general? With so many large banks failing, it doesn't seem like the current model of large banks eating up small ones is going to continue to be viable. Will we be going back to the era of the local community bank where the tellers know your name?

Binyamin Appelbaum: If I could predict market reactions, I would go make money.

Once more for effect: Large banks are not failing.

The government has actually declared, quite remarkably, that large banks are not even allowed to fail.

And the reason is simple: The government believes that large banks are too important to live without.

Others disagree, but they're not in charge.

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That said, I'm not sure failing this test is the greatest of their sins.: Then what is?

Binyamin Appelbaum: Paying clever people obscene sums to make stupid loans. Taking advantage of the traditional role of banks as intermediaries to milk the economy, prospering the few at the expense of the many, and ultimately tanking the system. Ignoring that corporations are creatures of the state, created to serve societal functions. Arrogance, greed, sloth, vanity, avarice, pride. I can never remember the whole list of seven, and I guess they did miss a few.

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Sorry: I guess I should have asked: will small banks be discouraged from merging to form mega banks, given that large banks have shown more signs of instability now than ever before?

Binyamin Appelbaum: That's an interesting question. I don't know how this will affect the willingness of regulators to allow such mergers. I'd guess they haven't figured it out either.

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Mt. Lebanon, Pa.: Neal Wolin is having his confirmation hearing now for the job of Treasury Undersecretary. Live on C-SPAN. Do you know anything about him? Is he another Rubin/Geitner clone?

Senator Joe Lieberman, the best buddy of Wall Street from CT, introduced him. Do we really need another friend of Joe's working for us at Treasury? Those of us who want a real accounting re: the U.S. banking and investment industry, that is. An absolute necessity for our economy and society to get off of its backside.

Thanks much.

Binyamin Appelbaum: I'm afraid I don't know anything about him, but check out the profile on our sister site, WhoRunsGov.com, available here.

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Binyamin Appelbaum: Alright, that's all the time we've got. Appreciate the good questions. Enjoy the weekend.

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