Why the Banks Still Aren’t Fixed

5 problems that could derail a financial recovery.

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The stress tests are done. The results are better than feared. Bank stocks are up. A few large lenders, such as Capital One, US Bancorp, and BB&T, are even preparing to repay billions in federal bailout money. Sounds like the bank crisis is solved!

Except for everything that could still go wrong. "Yes, everyone passed the stress test, but it was a questionable test to begin with," writes Charles Rotblut of Zacks Investment Research. "Foreclosures are still rising, credit card defaults will get worse, and, despite all of the analysis, nobody still knows how to value the toxic assets."

[See 6 stress-test surprises.]

The Federal Reserve, in fact, thinks the loss rate on loans at the 19 biggest banks could end up even worse than during the Great Depression. That doesn't sound like we're out of the woods. That sounds like we're trudging deeper in. Here are the biggest challenges the banks still face.

Huge losses. The Fed estimates that the 19 biggest banks could lose up to $600 billion over the next two years. There are so many billions flooding out of Washington these days that perhaps that number doesn't seem all that large. It is. To put it in perspective, the 19 banks have lost a mere $400 billion over the past 18 months, yet that's been enough to drive Citigroup and Bank of America to the brink of insolvency, severely disrupt the credit markets, and trigger a deep recession that would be a depression in the absence of vast amounts of government aid.

[See 5 signs the bailouts are getting better.]

With the economy as fragile as it is, additional bank losses that are 50 percent worse than what the banks have already endured will continue to threaten the solvency of some banks. And the Fed's loss estimates are lower than others. There's a lot of pain still to come.

Massive defaults. For most of the past 50 years, the loss rate on all bank loans has stayed well under 2 percent. The Fed estimates that over the next two years the loss rate could reach 9.1 percent. You know all those historical comparisons that end with "the worst since the Great Depression"? Well, 9.1 percent would be EVEN WORSE than during the 1930s. Still looking forward to a soft landing or a quick recovery?

The Fed projects that the median loss rate could hit 8 percent on mortgages, 10.6 percent on commercial real estate loans, and 22.3 percent on credit card loans. A number of banks that made riskier loans face loss rates that are much higher. Banks can't just absorb losses of that magnitude and briskly bounce back. To survive, they'll have to sell assets, hoard cash, curtail lending, and simply wait it out. None of that generates economic growth.

[See more companies likely to fail this year.]

Wounded giants. The stress tests accomplished some important things, and one of them was giving healthy banks a pathway to repaying their government loans and getting back to business as usual. Unfortunately, some of the biggest banks are still in intensive care. Here are the four banks to watch: Citigroup, Bank of America, Wells Fargo, and GMAC. They account for half of all the assets of the 19 banks tested and 86 percent of the capital that the combined banks need to raise. And they've received about $133 billion in government aid, more than 60 percent of all the bailout money injected into banks. In other words, the nation's biggest financial companies are still in precarious shape, which will impede their ability to lend for months or years and soak up capital that would otherwise go to healthy firms. In the best case, that will continue to be a major drag on the economy.

[See the best and worst bailed-out banks.]

Those stubborn toxic assets. By pronouncing the banks healthy enough to muddle along, the Fed has in effect given a reprieve to banks that might have been on the verge of more dramatic action. That could affect the government's public-private investment partnership, or PPIP, Treasury Secretary Tim Geithner's plan to create a market for money-losing mortgage-backed securities and other troubled assets that have become cement shoes threatening to submerge many banks.

With home values plunging and foreclosures skyrocketing, the value of securities linked to mortgages has been in free fall. Banks could sell such securities for perhaps 30 cents on the dollar, but booking the huge losses that would ensue could trigger insolvency. So the banks are just sitting on their troubled assets, hoping that at some point their value will go back up. To many investors, regulators, and customers, that's the equivalent of deciding to set off a bomb tomorrow instead of today.

[See the banks most likely to pay back their bailout funds.]

The PPIP was designed to create a market for troubled assets at prices the banks could live with. But banks may be even less inclined to sell those assets now, since the stress tests have effectively bought time for the sickest banks. "The PPIP will probably be slowed, if not stopped," says Peter Wallison of the American Enterprise Institute, who's also a former top Treasury Dept. official. "Banks are much less likely to sell assets than before." If so, the thorniest problem in the whole banking crisis will continue to go unresolved.

More stress ahead. The Fed's stress tests aren't sacrosanct, and they could turn out to have been far too lenient. In the worst-case scenario, for instance, the unemployment rate for 2009 was pegged at 8.9 percent—which happens to be where it is now. With unemployment forecast to rise for the rest of the year, the average for all of 2009 is likely to be higher than 8.9 percent, which in turn would lead to higher default rates and even deeper bank losses than the Fed predicted.

[See why optimism over the economy is premature.]

The Fed also scaled back initial capital levels for several stress-test banks, according to an enterprising Wall Street Journal story. The Fed reduced its requirement for Bank of America by $16 billion, for example, and its requirement for Wells Fargo by $3.6 billion. There may be valid reasons for the reductions. But wishful thinking has been a hallmark of the entire financial crisis. We may be guilty of it again.