Curing The Bank Hangover
America's banks are suffering from a hangover of their own. It was brought on by the excess of a decade long lending and borrowing spree. Now they are on the eve of perhaps the most important exam in the history of modern American finance.
"The purpose of the test," Federal Reserve Chairman Ben Bernanke told a Senate committee "is try and ensure that even in a bad scenario, banks will have enough capital, including enough common equity, to meet their obligations to lend."
Beginning tomorrow, federal officials will examine the books of this country's biggest banks. These stress tests are designed to figure out how much money the troubled banks have on hand compared to how much money they owe to lenders and are owed by borrowers. If their ratio of capital (money and liquid assets held by the banks) to leverage (debt and obligations) is not wide enough, the U.S. government may be forced into some very difficult decisions.
Federal officials tell CBS News that these stress tests will be conducted at the 20 US banks with $100 billion or more in assets. The tests are essentially computer programs that will run worst case scenarios against each banks balance sheet. The idea here is to see if the banks have enough money over the next two years to survive even greater financial stress that we are all experiencing now - if that's imaginable. It's a pretty straightforward idea. Where things get a bit nuanced is how the stress test is graded.
"The outcome of this test is not going to be we say you pass and you fail," Bernanke said.
A pass/fail system may work in school ... but avoiding a pass/fail grading system on the banks may make sense on a number of levels. First - who wants to do business with any bank that fails a government stress test? If you thought the lines outside IndyMac were impressive, imagine the chaos if Citigroup, Bank of America or Wells Fargo were graded with an "F." It would also be politically impossible to get the Congressional and public support needed to throw billions more at any "failed" bank.
A "pass" grade would also be misleading. Few of the major banks are completely free of potentially balance sheet wrecking assets or relationships with vulnerable institutions. Even JP Morgan Chase, which many analysts agree has done a brilliant job of navigating through this crisis, must be very careful in the months ahead.
So instead, regulators will use what has been described to CBS News as a "range of results" to diagnose the condition of each of the banks. Banks deemed to have insufficient capital cushions will be encouraged to seek more private investment. Institutions that fall far short of what they would need in a worst case scenario will be allowed to convert the government investments (preferred shares) made since last fall into common stock.
The preferred stock/common stock option is a brilliant accounting solution to a political problem. It gives the most distressed banks immediate access to more capital without requiring the Obama Administration or the Federal Reserve to cut more bailout checks.
The results will not be released to the public regardless of the stress test outcome. It's clearly a decision aimed at keeping an already spooked stock market from going off the deep end.
"News of the stress itself, causes stress," observed Sen. Chris Dodd, D-Conn.
Still, such secrecy is an odd policy decision considering the U.S. taxpayer already has $700 Billion invested in this mess. Who can guarantee word will not leak out? Just ask Alex Rodriguez about the security of test results.
Bernanke is probably right. Pass/fail may not be the most practical way to grade the banks. But a reasonable argument could be made that such a zero-sum grade could let taxpayers know if their good money is being thrown after bad. At least then, the nation could decide whether it was finally time to stop payment on its checks and drag the kids with the hangovers back home.