Weak Banks Need To Raise Extra Capital

How can the banks that need to raise more capital do it? David Wessel of The Wall Street Journal talks with Renee Montagne about what the financial institutions can do to raise the money.

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RENEE MONTAGNE, host:

We turn now, as we often do, to David Wessel. He's economics editor of the Wall Street Journal. Good morning.

Mr. DAVID WESSEL (Wall Street Journal): Good morning, Renee.

MONTAGNE: Stress tests. David, last year the government went to great effort not to point to any one bank as being particularly weak, so they made all banks accept TARP money; that was one of the reasons. But now, these stress tests do separate the weak from the strong. Why the change now, and what might be the repercussions?

Mr. WESSEL: Well, that's absolutely right. Last year, when the government put money in to the banks, it told the nine big banks they had to take money whether they wanted it or not, and leaned on the strong banks to take the money so the weak wouldn't stand out. Now, they are going out of their way to distinguish between the weak and the strong, and I think they're doing it for a couple of reasons. One is that the cloud over the weakest banks was creating what Secretary Geithner called a fog of uncertainty over all the banks and making life miserable for all of them.

Secondly, it wants to liberate the strong banks to go out there and lend and get the economy going again, and pressure the weak banks to come up with a plan to strengthen themselves. It's a very interesting experiment, actually, in transparency, in saying that we're going to be very open about our opinion about these 19 big banks.

You're going to see some ugliness as well as some beauty, and we're hoping that that will help the markets function better, not scare everybody that the situation is terrible.

MONTAGNE: Now, we've just heard that the Bank of America, among other large banks, will need to raise billions of dollars in capital. How are they going to do that?

Mr. WESSEL: That's right. Of the $75 billion that the government says the banks now need to raise, about $34 billion of that is one bank, Bank of America. We can see from Citibank that there are ways to do this by converting what's known as preferred stock into common stock. So Bank of America will do quite a bit of that.

Bank of America, like any bank, has a couple of choices now. If they can, they'll go out and raise equity by selling shares. Wells Fargo and Morgan Stanley said yesterday they're going to do that. They can sell off businesses, and then they take the money and put that into their capital cushion. They can do this conversion of preferred stock, either preferred held by private investors or by the government already, and convert that.

Or the worst case for the banks is they can't do it privately, and they have to come to the government, and the government will give them more taxpayer money to make them strong enough to withstand a very weak economy.

MONTAGNE: Well, that TARP fund still has something like $109 billion left in it. What are the chances that the banks will go back - or rather, the Treasury will go and ask, for the banks, some of this money?

Mr. WESSEL: We asked Secretary Geithner that yesterday, and he said that there's enough money in the TARP now, plus the money that will be paid back by some of the stronger banks, to make good on the capital needed in this adverse scenario, the bad economy that they put into this exercise and the losses that they anticipate if things get bad.

So he says that he doesn't think they'll need to go immediately. But he repeated, as President Obama has, if they need more money they'll go and make the best case they can to Congress for it. And I think that one advantage of this whole exercise is it would allow President Obama to say to Congress that if we do need - if he thinks the banks do need more taxpayer money, look, I did everything I could to avoid getting to this point, and now we need some.

MONTAGNE: If, in fact, the Treasury does put more money into these banks, will management - will we see management be fired?

Mr. WESSEL: I expect so. Secretary Geithner was very cagey about that yesterday, but he said that if the taxpayers had to put a significant amount of more money into any one bank, they'd review their managements. I think that's a code word for, if they have to take a bigger, bigger stake in these banks, it suggests that the bank managements have failed and they - probably the political pressure to put new people in would be very strong.

MONTAGNE: Now, just briefly, David, now that the government is done with these stress tests, does that mean there are no big surprises coming down the line from the banks?

Mr. WESSEL: Boy, I hope so, but I doubt that. I think - what we know is that the examination has been for three months, 150 federal bank examiners and economists going through the books of the banks. One hopes is that if there's any really big surprises in there, they would have found them.

But these banks are huge, and the economy is still very treacherous, and there's always the possibility that there's some unknown out there or that the economy takes such a big turn for the worse, that the bank - or one of the banks runs into unanticipated problems.

MONTAGNE: David Wessel is economics editor of the Wall Street Journal. Thanks very much.

Mr. WESSEL: You're welcome.

(Soundbite of music)

MONTAGNE: And you can get the complete results of the government's stress tests at npr.org.

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Q&A: How The Banks Fared On Their Stress Tests

The Fed's Report

The Federal Reserve stress-tested 19 of the country's largest banks to see how they might fare in worsened economic conditions, and the results of those tests became public Thursday.

The government's goal is to inspire confidence in the banks, so investors will put their money back into the financial sector. But the test results exposed weaknesses in some banks, most notably Bank of America.

In all, 10 of the banks will need to raise new capital to get a bill of health from the government. Here are answers to some key questions about the test results.

Who fared worst? Who fared best?

Among the worst off are Bank of America, Wells Fargo, GMAC and Citigroup.

Bank of America used to be considered among the best, most stable of banks, until it acquired brokerage giant Merrill Lynch last fall. That move led the bank to seek $45 billion in capital from the government, and soured Chief Executive Officer Kenneth Lewis's reputation among investors. After conducting the stress tests, the government told Bank of America it would need to raise $33.9 billion in additional capital.

Wells Fargo will need to raise an additional $13.7 billion, and GMAC will need to raise $11.5 billion, according to the Federal Reserve's report.

Citigroup, meanwhile, also has a long row to hoe, despite already receiving $45 billion in aid from the government, which owns more than one-third of the bank. It needs to raise an additional $5.5 billion in capital.

Among those that passed the tests: JPMorgan Chase, Goldman Sachs, American Express and Bank of New York Mellon. All were told they won't need a fresh infusion of capital.

Some banks want to repay the Troubled Asset Relief Program (TARP) money they received from the government. How will that work?

In recent months, JPMorgan and Goldman Sachs both said they want to pay back the government loans and don't want to be subject to the added government oversight, including restrictions on executive pay. In order to return the government funds, the banks will have to show they can raise new debt without insurance from the federal government. The government wants to make sure these banks will not need another bailout after they've returned the money.

What do the weaker banks need to do?

They need to raise more capital. The government has urged them to do so from private sources, or by converting preferred shares — which are a burden on balance sheets because they pay dividends — to common shares. The Treasury Department is a major owner of those preferred shares. It acquired them in the initial phase of the financial bailout last fall.

It's an open question whether some of these banks can raise additional capital by issuing new shares to the public. That assumes there is enough private investor demand.

Alternatively, some of the banks, including Bank of America, are considering selling off some of their assets to raise money.

The administration has said it does not want to have to make up any capital shortfalls through additional federal bank bailouts. However, regulators said they could convert the government's preferred shares for common shares if conditions worsen substantially for the banks and they cannot raise private capital.

If my bank did not fare well with the stress test, should I worry about my deposits?

Likely not. All depository accounts of $250,000 are insured by the Federal Deposit Insurance Corp. The vast majority of accounts are below that limit, and you might qualify for separate federal insurance above the $250,000 limit if you have different accounts in different categories or banks.

Does this mean more banks are likely to fail?

The administration is touting the stress tests as evidence that none of the 19 tested banks will fail, even under "significantly more adverse" economic conditions.

Critics of the stress tests say the Obama administration is effectively choosing winners and losers in the market. Others say the stress tests weren't rigorous enough, and that if the economy worsens dramatically, banks could still be at risk.

But the most important thing these tests do, as far as Wall Street is concerned, is quantify how much risk existed among the largest banks. In fact, as details of the reports leaked out earlier this week, stocks rallied.

The tests only covered the big banks that account for two-thirds of all assets in the country, but these large banks aren't the only ones under scrutiny from regulators. The number of banks on the FDIC's troubled bank list (these are mostly banks not subject to stress testing) has grown to 252, up from 171 in the third quarter of last year. Deposits at those banks are federally insured, but many more bank failures could stress the FDIC's insurance fund. The money for the fund comes from insurance premiums paid to the government by banks.

What kinds of changes are being proposed to prevent a financial collapse in the future?

FDIC Chairman Sheila Bair told Congress on Wednesday that she thinks the system needs to change, so that huge multinational banks don't pose such big systemic risks that they are considered "too big to fail." She proposes establishing a council — made of various banking regulatory agencies — to ensure that banks aren't taking too many risks.

What were the criteria the government used to "stress test" the banks?

The government laid out two macroeconomic "what if" scenarios for the economy over the next two years. The tests analyzed what would happen to each bank's real estate assets, business loans, credit card holdings, securities — essentially all their assets and liabilities.

The value of some banks' assets — real estate holdings, for example — are fluid and subjective, so all the assumptions the banks used in valuing those assets were also subject to review by government representatives from various regulatory agencies.

The first scenario assumed a 2 percent decline in gross domestic product this year, and a rebound next year, when the economy would grow 2.1 percent. Unemployment under this scenario would reach 8.4 percent this year, then 8.8 percent in 2010. Housing prices would fall 14 percent this year and an additional 4 percent next year.

The second, worse scenario calculated the banks' viability if GDP fell 3.5 percent this year and grew only 0.5 percent in 2010. Unemployment, in this case, would hit 8.9 percent this year and 10.3 percent next year, while home prices would fall 22 percent this year and 7 percent in 2010.

Some have said the Fed's scenarios are not dire enough — with unemployment headed to 9 percent or more, according to some economists — and that even the worst-case scenario is not rigorous enough.

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