Fed pulls back curtain slightly on stress tests

Regulators say they want to help the public understand the methodology behind the tests, but provide few new details on the health of the 19 big banks tested.

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By David Ellis, CNNMoney.com staff writer

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NEW YORK (CNNMoney.com) -- Top banking regulators offered a detailed view Friday into the workings of an Obama administration program aimed at assessing the health of the nation's largest banks.

The widely-anticipated report, however, offered few details about the underlying health of the 19 institutions with more than $100 billion in assets at the end of 2008 that were subjected to the so-called "stress tests."

Regulators acknowledged in a 21-page document about the tests that most U.S. lenders were currently well capitalized, but that losses associated with the recession and turmoil in the financial markets had eroded the capital levels of some financial institutions.

The list of banks has never been officially disclosed but banks that fit regulators' criteria include Citigroup (C, Fortune 500), JPMorgan Chase (JPM, Fortune 500), Wells Fargo (WFC, Fortune 500) and Bank of America (BAC, Fortune 500).

Regulators indicated they have had preliminary discussions about the results of the tests with the banks, but that their full assessment would not be made public until May 4.

One senior Federal Reserve official said the decision to provide greater detail on the program's methodology Friday was done primarily in order to help the American public better understand the process by which they evaluated the nation's leading banks.

Industry regulators adhered to the same testing standards which were outlined by the Treasury Department when the program, which is officially known as the Supervisory Capital Assessment Program, or SCAP, was first announced in late February.

Regulators, including the Office of Thrift Supervision and the FDIC, have been looking at the performance of different assets owned by banks, including loans and exotic securities like collateralized debt obligations, under two different scenarios.

One would rely on current consensus economic expectations, while the other would focus on a more "adverse" scenario in which unemployment climbs above 10% and home prices suffer an additional decline of more than 20% over the next two years.

Banks were also asked to conduct tests of their own under the two scenarios, according to regulators, and encouraged to provide more specific loss projections across loan portfolios such as commercial real estate and credit cards.

Regulators also defended their decision to not divert from the conditions of the two economic scenarios, even as unemployment levels and home values have worsened since the program was first announced in February. One senior Federal Reserve official noted they were trying to rely on plausible forecasts, without being overly severe.

White House officials have said the central aim of the program was to help regulators identify which banks may require additional government support and how much they might need.

By providing struggling banks the funding they need, regulators said they ultimately hoped to avoid the failure of a large financial institution, a position that Federal Reserve Chairman Ben Bernanke has publicly defended.

Senior officials at the central bank, however, took pains to stress that the requirement of additional capital by any of the 19 banks should not necessarily be considered a reflection of either their viability or solvency.

Major indexes pared some gains immediately after the report was released before shooting higher again. So did bank stocks, which have led a broad market rally over the past few weeks.

Still, there are nagging concerns about how the market will react when the full details of the tests become public a week-and-a-half from now.

Banks that are deemed to be drastically undercapitalized by regulators could endure another painful selloff on fears that they will have to sell more stock to raise capital, which could further reduce the value of common shareholders' investments.

When the stress tests were outlined in late February, regulators indicated that banks which become undercapitalized in a more severe economic climate would have six months to secure capital on their own. Only if those efforts failed would the government step in to provide additional funds.

It is widely believed that banks could pursue a handful of options to raise additional capital on their own -- including asset sales or through an offering of new stock. But many experts doubt that investors will have an appetite for shares of a bank that is thought to be in financial trouble.

At the same time, there are indications that the government is running out of ammunition to try and fix the nation's banking system. A report published this week by the special inspector general overseeing the Troubled Asset Relief Program, noted that only $110 billion of the original $700 billion available through TARP remains unallocated.

Some financial institutions may pursue converting some of their existing government preferred shares into common stock to help boost their capital levels, much like what was announced with Citigroup in late February.

Sheila Bair, chairman of the Federal Deposit Insurance Corporation, the banking industry's lead regulator, encouraged banks Friday to consider this approach first before seeking additional government funds during a speech in Washington Friday. To top of page

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