Federal regulators released the much anticipated methodology to the stress tests performed on the 19 largest U.S. banks to assess their capital needs under a worsening economy on Friday. "Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized," the Federal Reserve said in a white paper. "However, losses associated with the deepening recession and financial market turmoil have substantially reduced the capital of some banks." Banks including Bank of America ( BAC), Citigroup ( C) , JPMorgan Chase ( JPM ), Wells Fargo ( WFC), Goldman Sachs ( GS), Morgan Stanley ( MS), PNC Financial Services ( PNC), Bank of New York Mellon ( BK) and smaller regional banks were among those that the government tested.
In all, 19 banks with assets over $100 billion participated in the government stress tests, which started Feb. 25 and were completed over the course of two months. Those banks hold more than two-thirds of the nation's assets and more than half the loans in the U.S. banking system. The report estimates that these banks took approximately $400 billion of losses in the six quarters through the end of 2008. "Given the heightened uncertainty around the future course of the U.S. economy and potential losses in the banking system, supervisors believe it prudent for large bank holding companies to hold additional capital to provide a buffer against higher losses than generally expected and still remain sufficiently capitalized over the next two years and able to lend to creditworthy borrowers should such losses materialize," the paper said.
For the baseline scenario, regulators assumed that real GDP would fall on average 2% this year and 2.1% next year. It also said that the unemployment rate would be 8.4% for 2009 and 8.8% for 2010. Home prices were expected to fall 14% this year and 4% next year. Under the more adverse projection, the average real GDP was expected to fall 3.3% this year and 0.5% next year. Unemployment would be down 8.9% this year and 10.3% next year, while home prices would plunge an additional 22% this year and 7% next year. Following the guidance, the banks were asked to estimate potential losses on loans, securities and trading positions over two years, beginning with year-end 2008 financial data, the Fed said. Banks were instructed to provide forward-looking losses "due to failure to pay obligations" rather than markdowns related to mark-to-market values on multiple loan categories. The categories were first- and second-lien residential mortgages, credit cards and other consumer loans, commercial and industrial loans, and commercial real estate loans. It also included loans deemed as "other," such as farmland lending, loans to other depository institutions and loans to the government, among others. Securities available for sale and held to maturity were also included in the tests, such as Treasury securities, government agency securities, sovereign debt and high-grade municipal securities. The government also asked for losses on trading portfolios and counterparty credit risk, the paper said. Banks were then asked to project pre-provision net revenue and what capital would be available to absorb losses under the two macroeconomic scenarios.
The firms were asked to provide "supporting documentation for their projected losses and resources, including information on projected income and expenses by major category, domestic and international portfolio characteristics, forecast methods, and important assumptions." Recent economic indicators show the economy is approaching the more severe of the government's two scenarios, analysts have noted. The results of the stress tests won't be publicly released until May 4. The slow-motion rollout is intended to blunt market reaction to the news of which banks are healthy, which ones could fail if the recession worsens and which need more money to survive. News reports have led analysts to start handicapping which banks could in the most trouble. The speculation is expected to intensify with the release of the test methodology.