Bank 'Stress Tests' Expose Cracks

BofA and Citi may need to raise capital.

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Banks have until May 4 to appeal the results of the government's "stress tests" designed to determine whether they've hoarded enough capital to continue functioning. Already, the results seem to hint the financial crisis will continue. All of the 19 largest U.S. banks under scrutiny are expected to "pass" but that's not really the point. Some are still expected to be forced to raise new capital no matter their grade. 

Which brings us to Bank of America and Citigroup, two banks reportedly being urged by the government to raise capital. That banks are undercapitalized is no big secret. Unfortunately, new concern for two institutions that have already taken a combined $95 billion in bailout money could increase the chances they'll come back for more. The longer their capital structures are questionable, the less chance the pair will be able to convince investors to come creeping back especially as the perception problems plaguing the sector remain firmly entrenched. Officials say they don't want the market to look unfavorably on banks required to up cash reserves, or to consider them insolvent. But that is unlikely.

At the same time, obfuscation surrounding bank credit quality continues. As the WSJ points out, there remains a possibility that the banks could "meet" their capital requirements by extrapolating future results based on recently massaged balance sheets. From the end of the WSJ article:

Some bankers are optimistic that the Fed will use their first-quarter numbers to predict their performance for the next two years.

That could inflate the banks' earning potentials -- and thus their capital cushions -- because many of the companies had strong first-quarter performances.

Analysts, investors and most executives say those results probably aren't sustainable.

Those first quarter numbers, remember, came care of a change to reporting rules, not surprise profits. Inflated forecasts based on inflated results. What would be new there?

As for sorting out which banks are still at risk consider the following from Martin Weiss, who warns that despite reassurances from the Fed that the Big 19 are well capitalized, his research shows:

  • None currently merit a rating of B+ or better, a level that we believe would generally correspond to capital levels well in excess of needed amounts.

  • Only three, representing 6 percent of the assets of the 19 — have a rating of B- or B, — considered “good.” They are Bank of New York Mellon, Capital One and State Street.

  • We consider eight institutions, representing 63 percent of the assets, to be at risk of failure. They are JPMorgan Chase, Citibank, Wells Fargo, SunTrust, Goldman Sachs, HSBC America, National City and Countrywide Bank.

Notice the number of  "healthy" banks (Goldman, JP Morgan) on that list. Weiss says hefty ongoing exposure to derivative risk is part of the problem, and concludes both the stress tests and their results could be "very misleading."

  • Kirk Shinkle

    Kirk Shinkle is a senior editor for U.S. News Money and manages the Best Funds portal. Follow him on Twitter @KirkS or email him at kshinkle@usnews.com.

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