Stressed Out?

Call it the great cap rac(is)e; 10 banks, 6 months and $75 billion in capital to raise.

As the news of the stress test on top banks of US trickles down Wall Street there is mixed reaction among investors and analysts alike, but the bottom line is; it is not that harsh as everyone once imagined.

The stress test was carried out for 2 months by the Treasury department with the help of 150 regulatory officials pouring over the books of 19 largest banks in US, to clearly draw a line between weak and strong and to exactly quantify the amount of capital injection required to bail out the banks. They were measured against two scenarios 1. A 'baseline' assumption that recession continues along the estimates of analysts and 2. A more adverse circumstances where recession dives deeper with greater unemployment and large credit problems etc., The results were made public on Thursday which shows that out of 19 banks, 9 are in good health and the other ten need to quickly sketch out their course of action to raise additional capital (course of action should be submitted to treasury department within the next 2 months). This was carried out to restore faith in the biggest financial system and to assure that there is a way to move forward in a worst case scenario. As far as it goes for the big 19 it was an acid test to prove that they should be granted right to continue business.

However there was mixed reaction to the parameters considered for the stress test. Some said that the treasury department has painted a very gloomy picture and some analysts voiced that the test was not rigorous enough. Consider this as an example from the pessimists, government considered unemployment to reach 8.9% in a worst case scenario, but the data from US labor department very recently pointed unemployment rate at 8.9% in April 2009.

Bank of America (BoA) emerged as the weakest with almost $34 billion required to fill the hole, next was Wells Fargo with $13.7 billion requirement, GMAC was third with $11.5 billion, followed by Citi group ($5.5 billion) and Regional finance with $2.5 billion (See table for complete details). GMAC will have the hardest time of all not because of its loan performance but due to its exposure in Mortgage market through its ResCap unit and also due to its heavy reliance on a single customer, the troubled carmaker GM.

The troubled banks are already on course to raise additional capital. BoA is planning to sell assets, issue $17 billion in common stock and other steps to fill the gaps in the hole. Morgan Stanley has already sold $3.5 billion in stock as has Wells Fargo with $7.5 billion. Though the shares were sold on heavy discounts of around 11% it was better than expected price for both deals. The bank shares traded higher than expected on Friday morning, Morgan Stanley shares slid 6.4% to $25.39 after the news that it had sold 146 million shares at $24.00 each. Wells Fargo took the same course at $24.89 after it said, it had sold 341 million shares at $22.00 each. The banks like Morgan Stanley and others who have a lot less capital hole to be filled are already thinking of repaying the $10 billion capital it received last fall under treasury's TARP (Troubled Asset Relief Program). While other banks are still orienting themselves to devise a course of action to raise capital. Banks like Morgan Stanley can quickly plan strategies to pay back the TARP funds and attract customers out of the troubled banks.

Even if all of them manage to raise the required $75 billion, the question would be, will it be enough? No says Bert Ely, an independent banking analyst; since the government also says there could be close to $600 billion in bank losses, so in simple terms; they need more than what they are really looking for. Also Dan Alpert, Managing director of Westwood capital points out that the numbers have been artificially bolstered due to assumption of near zero cost of funds, a residential mortgage re-financing boom and government guarantee against losses from nearly every activity inherent in banking. If Q1 results are anything to go by then we are recovering sharply, but the real problem lies in the remaining 3 quarters. Analysts predict that slow growth will kick in and banks will be more concerned about preserving their capital than lending it out, a blow for those who are praying for speedy recovery. There is also a simple fundamental question: how can a bank perform better if non performing loans get continually worse?

Having said that, all is not grey and gory. There are many reasons to believe an optimist's point of view. Federal Reserve chairman Ben Bernanke has said in a statement that Fed has the tools to soak up more than $1 trillion in liquidity that the US bank has pumped into the banking system under TARP. The test results also won applause for the relatively small hole that the banks need to fill. This can be tracked in-line with the upward movement of banking stocks since the release of stress test result, not only that the DJ (Dow Jones) banking sector rose 2.2% and the index has doubled in the past two months. Even after the result, a large number of banking stocks were sold in the market at a premium indicating that the market has already absorbed the results which was better than expected. One major boost is that analysts have predicted there are no new threats for banks in the near future. The market went on a rampage, in fact BoA rose 4% when Kenneth Lewis, CEO, BoA, announced that it is better able to raise the capital than the government estimated in its stress test.

The road ahead

So all in all we will have to wait and see what course the market takes in the near future and it will be interesting to see if the banks are be able to raise new capital to keep them in business. One thing is for sure the banks who are better off with the capitals will now concentrate on repaying the TARP capital injection to avoid the strings that are attached to it in case of repayment failure and the management of the troubled banks will spend most of their time cleaning up the mess and raise additional capital.

After the long and hard battle the government expects to place new regulations to reduce excessive leverage and try to prevent all of this from happening again. Having said that innovative financiers will no doubt come up with products to hedge risk and disperse capital. So you can be sure of one more slump in the not so near future. As far as the Treasury and Fed go they will spend most of their time tweaking the policies. Ben Bernanke has already said that portions of banking law stand in the effective supervision and has urged the Congress to revise the Gramm-Leach-Bliley to ensure supervisors have necessary tools and authorities to monitor and address safety and soundness concerns in the banking system.

P.S., Just as I finish writing this article I have received a feed stating that Wells Fargo has raised $8.6 billion through a stock offering on Friday. Morgan Stanley has also found willing investors on Friday, raising almost $8 billion through debt and equity offerings beating the goal by billions. WF had only planned to raise $6 billion but heavy over-subscription saw them raise $8.6 billion at the top end range of $22/share. Not only that, Wells shares closed at $28.18 on Friday, up nearly 14 percent. Phew, finally much to rejoice and stay positive.