Bank stress tests to clarify U.S. credit crisis

The true dimensions of the U.S. credit crisis will become much clearer next week with the release of results from unprecedented government stress tests of the nation's 19 largest banks and their capital needs.

The results are expected to show that the 19 banks must raise possibly $150 billion or more in fresh capital, with investors expected to punish stocks of the neediest banks.

Most banks will have to raise capital in some form, said FBR Capital Markets managing director Paul Miller. The capital raises will be much bigger than people think.

Uncertainty about what the tests might reveal had made banks stocks uninvestable at this point, he added. You just don't know how the government is going to view it.

Public release of the stress test results is set for Thursday, a government official said. A source told Reuters U.S. officials plan to brief the banks themselves on Tuesday.

The stress tests have transfixed markets for weeks, shaping a suspenseful episode in the ongoing financial crisis that has worsened the U.S. recession and shaken economies worldwide, burdening the newly arrived Obama administration and Congress.

It stems from hundreds of billions of dollars in shaky assets on banks' books. Accumulated during a massive debt bubble, when real estate soared and exotic debt securities multiplied, these assets are now clogging credit markets.

I can't think of a time since I've been watching banks when there's been so much uncertainty about the true value of a key set of assets, said Douglas Elliott, a fellow at the Brookings Institution, a Washington think tank. He estimates the 19 banks must raise between $100 billion and $150 billion.

The banks being tested include Citigroup Inc , Bank of America Corp , JPMorgan Chase & Co , Wells Fargo & Co and Goldman Sachs . Together, the 19 banks hold two-thirds of total U.S. bank assets.

CUSHION PADDING

When results are announced late next Thursday, analysts believe the government will say all 19 banks are solvent, but that some need to raise more capital than others to cushion themselves in case the U.S. recession deepens.

The banks likely to be tagged as needing the most fresh capital are Citi and Bank of America, said Fred Dickson, chief market strategist at D.A. Davidson & Co.

Below those two, the next banks needing the most capital will likely be JPMorgan and Wells Fargo, he said, adding that this would likely halt a recent recovery in bank stocks.

My guess is we will see another fairly significant sell-off of banks that are going to be involved, he said.

The recent market rally I think has been a lot due to short-covering.

Bank shares have rallied in recent weeks after some large banks posted surprise first-quarter profits. The KBW bank index <.BKX> is up 75 percent from a year low of $18.62 on March 6. It finished on Friday at $32.13.

Regulators are expected to urge banks to quickly boost capital by converting existing preferred stock to common equity, diluting common shareholdings, and will likely also be encouraged to sell assets.

The most vulnerable could face new government capital infusions, which would extend Washington's reach over the sector and potentially put some CEOs' jobs on the line.

Bank stocks have been under pressure on uncertainty about credit losses and rumors of nationalization. The banks' woes have hurt the overall market, helping to push the Dow Jones industrial average <.DJI> down 27 percent in the first two months of the year to a 2009 closing low in early March. It has since gained back more than 25 percent of its value.

The stress test results will disclose information about the 19 bank holding companies as a group and individually. They will also disclose estimates of losses for certain types of loans, and detail resources needed to absorb those losses under an adverse economic scenario, the government source said.

CREDIBILITY IN QUESTION

The government has said the tests are not about solvency, but a what if? exercise to help gauge the need for additional capital should the U.S. recession deepen unexpectedly.

The Federal Reserve, the regulator in the lead, said banks with inadequate capital will have six months to find private funds, but analysts doubt banks' ability to raise capital if the government pinpoints their vulnerabilities.

Some questions surround the tests, which have never been conducted before on this scale, as more than 150 bank examiners and economists were dispatched to perform a consistent inspection of the largest firms.

Chief among them is whether the direst economic scenario envisioned by regulators is dire enough.

Anil Kashyap, a professor of banking and finance at the University of Chicago and a former Federal Reserve economist, said it could be hard for regulators to prove they were tough enough. The stress scenario is a pretty weak scenario, he said.

In addition, FBR's Miller said, it is still unclear how banks will be made to treat setting aside reserves for bringing off-balance sheet assets back onto their balance sheets under recent accounting standard changes.

The Fed said last week that the changes could bring $900 billion of assets onto the 19 banks' balance sheets.

This off-balance sheet issue is a wild card, he said.

(Additional reporting by Kevin Drawbaugh; Writing by Kevin Drawbaugh; Editing by Simon Denyer and James Dalgleish)