The Obama administration on Wednesday began testing large banks to see how well they would withstand a deeper recession than the one the country already faces.
The stress tests, mandatory for the roughly 20 institutions with over $100 billion in assets, will be used to determine whether the banks need more capital from a new Treasury program for government preferred stock investments that can be converted into common shares.
The program, known as the Capital Assistance Program, will be placed alongside a previous program that has injected nearly $200 billion into banks since last October. Both will draw from remaining funds in the Treasury's $700 billion financial rescue fund.
The stress tests, to be conducted by end of April by the Federal Reserve, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency and the Office of Thrift Supervision, will measure banks against two economic scenarios. The first or "baseline" scenario is based on the consensus of private forecasters for the economy and the second or "more adverse" outlook anticipates a longer and deeper recession.
Regulators will conduct "an assessment of all these banks to try and figure out how much capital they need to meet even that weaker scenario," Federal Reserve Chairman Ben Bernanke told the House of Representatives Financial Services Committee on Wednesday.
Some banks will need funds
"Banks will be told how much capital they need to raise, if any. Some will not need any capital, but some will," he added.
Bernanke said banks will first have the opportunity to try to raise capital in the private market, but if they cannot do so, the Treasury will offer to buy convertible preferred shares in the bank.
"Currently, the major U.S. banking institutions have capital in excess of the amounts required to be considered well capitalized," banking regulators said in a joint statement.
"The CAP is designed to ensure that major U.S. banking organizations have sufficient capital to perform their critical role in our financial system on an ongoing basis and can support economic recovery, even in more severe economic environments," the statement said.
If losses grow, the preferred shares can be converted to common equity, giving the government a direct ownership stake and enhancing the bank's ability to absorb writeoffs.
The Treasury does not intend to disclose the results of the stress tests, leaving that decision up to banks. It said banks found by the stress tests to need more capital will have six months to either find private funds or take money from the Treasury which will charge a 9.0 percent annual dividend rate.
A government official told a background news briefing it was "important" that such banks do one or the other, but did not say what would happen if they refused.
Officials said the extra, temporary capital cushions would most likely be around one to two percent of an institution's risk-weighted assets, but there was no explicit limit the amount of capital the Treasury would give to large banks.
"We obviously stand behind the program. There's no explicit cap on the program," the government official said. "We stand ready to provide the necessary capital to the banking sector so it can be a contributor to the economy."
Existing home sales drop
The move came after news that sales of existing homes, a key barometer of the housing market, tumbled to the lowest in 12 years. The drop showed the depth of the problem facing banks and the economy.
Analysts said the stress-test scenarios were not as onerous as some had feared.
"I think a lot of people realize as they look at the details of this stress test that a lot of these banks are going to be able to pass it," said Stephen Massocca, managing director at Wedbush Morgan in San Francisco.
The baseline scenario assumes real gross domestic product will fall 2.0 percent in 2009 and rise 2.1 percent for 2010. The more adverse scenario assumes a 3.3 percent fall in GDP for 2009 and a rise of just 0.5 percent in 2010.
For the unemployment rate, the baseline assumes 8.4 percent for 2009 and 8.8 percent for 2010, with the more adverse scenario at 8.9 percent for 2009 and 10.3 percent for 2010.
For home prices, the baseline assumes a 14 percent drop this year, while the more adverse scenario assumes a 22 percent drop.
