Big Banks Brace For Crucial "Stress Tests"

The Obama administration hopes to restore confidence in the nation's ailing financial sector by subjecting 19 of the largest banks to "stress tests" that will gauge whether each institution has adequate capital to survive a severe downturn.

Banks that need new funds will be given six months to obtain it from the private sector or, failing that, from the federal government's $700 billion bank rescue program, the Treasury Department said Wednesday.

Treasury officials said the new support will be provided through the government's purchase of preferred shares of the bank stock that are convertible into common shares at a 10 percent discount to their price before Feb. 9.

The preferred shares will carry a 9 percent dividend and be convertible at the bank's option, but subject to regulatory approval.

The option to convert the preferred shares into common shares is a change in the rescue program designed to give the government greater flexibility in managing its assistance.

Common shares absorb losses before preferred shares do, which means that under a stock-conversion plan taxpayers would be on the hook if banks keep writing down billions of dollars' worth of rotten assets, such as dodgy mortgages, as many analysts expect they will.

However, common stock in banks is incredibly cheap, and taxpayers would reap gains if the banks come back to health and the stock price rises.

The Treasury Department also provided details of how a new stress test will function to ensure banks have enough capital to survive a downturn that would be even more severe than the current recession. The tests will be conducted by bank regulators, including the Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision.

Government officials hope the tests will boost market confidence in the banks by making it clear the institutions either have the necessary capital to weather a major downturn, or will obtain it from private investors or the government.

The results will help regulators decide whether banks may need additional assistance so they can carry out the critical mission of boosting lending to customers, a key ingredient to the economic turnaround.

Bank regulators said they wouldn't release the tests' results, but the banks will likely make some disclosure of the outcome, particularly if it shows they don't need more capital. Banks that seek private capital likely will indicate how much they need and the government will announce any new investments.

Administration officials did not say whether they expect to request more taxpayer money to fund the next round of investments in banks, beyond general statements that they would provide the capital that banks need.

But in his speech to Congress Tuesday evening, President Barack Obama said more money beyond the $700 billion committed last year would be needed. Saying he understands bank bailouts are unpopular, he insisted it was the only way to get credit moving again to households and businesses.

Mr. Obama also is urging key members of Congress to write tough new financial industry regulations to prevent crises and protect consumers.

The president called for new accountability, transparency and trust in the financial markets. Among his main principles for the legislation, he said, is that government better monitor the scale and scope of risks that institutions take.

Mr. Obama made his remarks Wednesday after meeting with the top Democrats and Republicans from the two House and Senate committees that will take the lead in writing the legislation. Central to the new regulatory effort are the unregulated esoteric financial instruments that have been blamed for Wall Street's free fall last year.

Meanwhile, Fed Chairman Ben Bernanke on Wednesday again spurned speculation that the government may nationalize Citigroup Inc. or other large financial institutions.

During an appearance before the House Financial Services Committee, Bernanke said nationalization "is when the government seizes the bank and zeros out the shareholders and begins to manage and run the bank. And, we don't plan anything like that."

But the Fed chief said it is possible the government could end up with a much bigger ownership stake in Citigroup or other banks. In the case of Citigroup, Bernanke said "we'll see how their test works out and what evolves."

Citigroup has been involved in talks with regulators over ways the government could help strengthen the bank, including use of the stock conversion plan. New York-based Citigroup already has received $45 billion in bailout money, plus guarantees to cover losses on hundreds of billions of dollars in risky investments.

The new stress tests will use two economic scenarios to gauge banks' health and are expected to be completed by the end of April.

The "baseline" scenario envisions the nation's gross domestic product, which is the value of all goods and services produced within the U.S. and the broadest barometer of the country's economic health, falling 2 percent this year, unemployment rising to 8.4 percent and home prices dropping 14 percent.

The "adverse" scenario assumes GDP will drop 3.3 percent, unemployment rising to 8.9 percent and home prices falling 22 percent this year.

For all of 2008, GDP rose 1.3 percent, which was the smallest increase since 2001. In the fourth quarter, GDP fell 3.8 percent, the biggest contraction since 1982.

The unemployment rate last month surged to 7.6 percent, the highest in more than 16 years. It was 5.8 percent last year, the highest since 2003.

Median home prices in the U.S. fell 9.5 percent last year, according to the National Association of Realtors, though many big cities like Los Angeles, Las Vegas and Miami showed far larger declines.