Fed Issues White Paper On Stress Test; Banks Need Reserves To Cover Losses Into 2011

As expected, the Federal Reserve issued a white paper on the process and methodologies employed on the 19 banks under their bank "stress tests." The Fed said the 19 firms collectively hold two-thirds of the assets and more than one‐half of the loans in the U.S. banking system. The results of the stress test are expected to be released to the public May 4th.

The banks were asked to project their credit losses and revenues for the two years 2009 and 2010, including the level of reserves that would be needed at the end of 2010 to cover expected losses in 2011, under two alternative economic scenarios - a baseline scenario and a more adverse scenario.

In early March the banks submitted their projections to the agencies. 150 senior supervisors, on-site examiners, analysts, and economists from federal agencies evaluated the data.

Results from the test may require banks to augment their capital base to establish a buffer. The Treasury will make capital available to banks that need to boost their capital and banks may apply to Treasury to exchange their existing preferred stock to meet their buffer requirement.

The average baseline scenario is looking for: GDP of a negative 2 in 2009 and a positive 2.1% in 2010; unemployment rate of 8.4% in 2009 and 8.8% in 2010; House prices down 14% in 2009 and down 4% in 2010.

The alternative more adverse scenario is looking for: GDP of a negative 3.3 in 2009 and a positive 0.5 in 2010; unemployment rate of 8.9% in 2009 and 10.3% in 2010; House prices down 22% in 2009 and down 7% in 2010.

The Fed stated that while the adverse scenario reflects a deeper and longer recession, it is not and is not intended to be a "worst case" scenario.

Yesterday analysts at KBW had a very extensive research report on the stress tests and even conducted their own individual stress tests on the banks, coming to the conclusion that the industry needs another $1 trillion in capital. This is close to the $875 billion the IMF says is needed.

In its study, the firm said Bank of America (NYSE: BAC) is one of the banks most at risk and they think it will be the most likely to convert some of the government's preferred shares into common. They think the government could end up owning 30% of BofA.

Other banks that may eventually need more capital, according to the firm, include: Fifth Third (Nasdaq: FITB), KeyCorp (NYSE: KEY), PNC Bank (NYSE: PNC), Regions Financial Corp. (NYSE: RF), SunTrust Banks, Inc. (NYSE: STI), and Wells Fargo (NYSE: WFC).

Banks that look in a good position to pass the test without any additional capital include BB&T (NYSE: BBT), Bank of New York Mellon (NYSE: BK), Capital One (NYSE: COF), Goldman Sachs (NYSE: GS), JPMorgan (NYSE: JPM), Morgan Stanley (NYSE: MS), State Street Corp. (NYSE: STT), US Bancorp (NYSE: USB).

The firm said MetLife (NYSE: MET) is too hard to call since it is a life insurer and it is unclear how the Treasury stress test will be applied.

Link to Fed Stress Test White Paper

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