Bank Stress Tests: No Big Deal

Bank stress test results expected to be unveiled by the government Thursday are not likely to tell investors anything they didn't already know.
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Updated from 11:23 a.m. EDT

Despite the heavy news coverage of rumored results and fretting among analysts and the public, the government stress test results expected to be unveiled Thursday are not likely to tell investors anything they didn't already know.

Wells Fargo

(WFC) - Get Report

Chairman

Richard Kovacevich made headlines in March by calling the tests "asinine," noting that banks routinely stress test all of their portfolios, and share the results with regulators. Furthermore, analysts perform similar tests independently, and use them as the basis of reports on a weekly if not daily basis, advising investors on whether to buy, sell or hold bank stocks.

Once the government released its stress test metrics -- the GDP declines, unemployment rates and implied loan losses that are expected under a variety of economic "scenarios" -- the tests became even less of a mystery, and investors seemed even less concerned about the results. As the rumor mill churned out word on Monday that 10 out of 19 major banks undergoing stress tests would need

additional capital, the market continued its charge upward, sending the

S&P 500

into positive territory for the year.

"They've been leaking information all week, so as long as they don't surprise the market, I think we're out of the woods for the near term," says Brenda Wenning, president of Wenning Investments. "I don't think anyone's surprised that banks need more capital."

The question seems not to be whether, but rather how much capital banks will need. Unconfirmed reports citing anonymous sources have pegged the government's estimate of shortfalls at both

Bank of America

(BAC) - Get Report

and

Citigroup

(C) - Get Report

in anywhere between $10 billion and $34 billion. A

New York Times

report on Wednesday put

BofA's shortfall

at $34 billion, but that amount could be satisfied by converting the government's preferred equity stake into common shares. Other unconfirmed reports said Wells Fargo will be pushed to raise more capital as well, though specific figures were not disclosed.

On the flip side,

American Express

(AXP) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

and

Bank of New York Mellon

(BK) - Get Report

do not need more capital,

The Associated Press

reported Wednesday.

But of course no one, including federal regulators, really knows how much the banks will need, because no one knows how severe the recession will become. In fact, so-called "green shoots" emerging from the housing market, combined with positive statements from the

Federal Reserve

, and better-than-expected economic data and earnings, have led some to speculate that the economy has hit a bottom, though employment continues to lag.

Even if the economy is poised for a rebound, it's unclear which banks are strong enough to earn their way through the remainder of the recession, and which banks have been competitively weakened, with bad loans hanging on balance sheets like bricks.

"Stress tests involve guesses about the future, and they can be wrong in either direction, just as risk-based capital models and bank examinations can be wrong," says William Isaac, former chairman of the

Federal Deposit Insurance Corp.

. "If models were always right, we wouldn't be in the mess we are in today."

Isaac, who is now chairman of global financial services for the consulting firm LECG, is sharply critical of the government's handling of the tests. Though he supports the testing, he thinking they could have been done quietly, without the leaks and eventual public disclosure -- which he calls a "stunning mistake."

"If the government refused to disclose the results, people would assume the worst," notes Isaac. "If the government announced that everyone 'passed' the test, many would assume a cover-up. If officials announced that some banks 'failed' the test, there would be a clamor for names, the release of which could prove disastrous."

Others have said that the stress tests may actually hinder economic progress, by preventing banks from using capital to make new loans. Rochdale Securities bank analyst Richard Bove, who has bullish outlook on the industry he covers aside from the impact of the stress tests, has said the tests "can create financial and economic havoc."

Both Bove and Isaac note that while the biggest 19 banks have been the target of stress test-related speculation, thousands of other banks across the country that are small enough to fail could be driven out of business if the same hypothetical scenarios were applied.

"Conceptually, this test still strikes me as being unnecessary, dangerous, and poorly conceived," says Bove.

Still, the government is aware of how big surprises can affect the market and the banks -- remember

Lehman Brothers

? -- which is probably why leaks have appeared in the media in the weeks running up to the results' release. The information seems to have been disclosed in a premeditated way, though it's unclear how much of it was accurate at the time, and how much of it will be confirmed on Thursday.

For instance, the government pushed back the date it was expected to unveil results to the public by three days to give banks additional time to dispute leaked results. When reports surfaced that regulators told BofA and Citi to raise $10 billion, Bank of America responded with a

strong denial, making it unclear who was leaking the information and for what purpose.

Then investors drove down BofA shares in premarket trading Thursday, following the

Times

report that said they need $34 billion, before the stock turned following an ADP report that showed April job loss was less than feared. It also may have been unclear to investors that the

Times

said BofA's capital shortfall could actually be covered by converting preferred shares to common -- meaning it might not need to raise new capital.

Despite the uncertainty, the haggling over results shapes the stress test as tough, but fair -- letting banks know they'd need to raise more funds, while giving them a chance to dispute findings. Furthermore, the release of the stress tests gives the government yet another opportunity to shift the tone of economic dialogue from one of "doom and gloom" to one that's "not so bad and getting better."

"How they use their words is very significant because they've been criticized for talking down the economy," says Lawrence Kaplan, former senior lawyer at the Office of Thrift Supervision, who is now in the banking and financial institutions group of the Paul Hastings law firm. "By releasing the results of the stress tests, they're considered to be honest brokers of information. But the way they're going to spin it is by saying, 'These are big numbers, but it's not as bad as it could be.'"

It's unlikely that the government will say that no banks need any money, since that finding would be unbelievable to even the most optimistic economist. And with a number like $34 billion floated as a trial balloon, it's unlikely that the feds will shock the markets with an enormous capital shortfall estimate for any of the top 19 banks.

The institutions undergoing stress tests are Citigroup, Bank of America, JPMorgan, Bank of New York, American Express,

Goldman Sachs

(GS) - Get Report

,

Morgan Stanley

(MS) - Get Report

,

MetLife

(MET) - Get Report

, Wells Fargo,

PNC Financial Services

(PNC) - Get Report

,

US Bancorp

(USB) - Get Report

,

SunTrust

(STI) - Get Report

,

State Street

(STT) - Get Report

,

Capital One Financial

(COF) - Get Report

,

BB&T

(BBT) - Get Report

,

Regions Financial

(RF) - Get Report

,

Fifth Third

(FITB) - Get Report

,

KeyCorp

(KEY) - Get Report

and

General Motors'

(GM) - Get Report

GMAC.

Four of those firms were not even considered banks just one year ago, but then again, neither are the three institutions that have received the most government support to date: insurance giant

American International Group

(AIG) - Get Report

, and the mortgage financing mammoths

Fannie Mae

and

Freddie Mac

.

Keith Gumbinger, vice president of the financial information group HSH Associates, predicts that whatever is disclosed about the health of these institutions from a regulatory standpoint won't have much of an effect.

"Even if some bad news is revealed, is there anyone at this stage of the game who could claim to be surprised by it, even if tens of billions of dollars of deficiencies were unearthed?" says Gumbinger in his weekly report. "We're hundreds of billions into losses already, and that just to a single company (AIG)."