By John W. Schoen Senior producer
msnbc.com
updated 5/6/2009 2:41:56 PM ET 2009-05-06T18:41:56

Fed Chairman Ben Bernanke has said he hopes the bank "stress tests" will help the "healing process" for Wall Street and the economy. Hope springs eternal.

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The results of the Treasury’s tests on banks have leaked out piecemeal, and instead of soothing nerves, the exercise has produced a number of unintended consequences, among them more stress for depositors and investors.

The original idea was to head off another bank meltdown that could send the financial markets back into a panic mode similar to last fall when Lehman Brothers collapsed. But conflicting information about the results and what they mean has produced a new series of headaches for banks, regulators and the public.

It has also left unsolved some of the fundamental problems the program was designed to address, and may leave some banks worse off when the process is over.

“I think when they announced this in February, they did that more to calm the markets,” said Cam Fine, CEO of the Independent Community Bankers of America. “They weren't really thinking about the end game and the exit strategy. And now they have to deal with this, and they're really in a lose-lose situation.”

The basic outlines of the process are pretty simple. With banks holding billions of dollars of loans and assets backed by real estate, and the real estate market still in decline, bankers have a hard time selling those assets, or even figuring out how much they’re worth. If the housing market and the economy recover later this year, those assets will be worth more than they would be if the recession grinds on and real estate prices continue to fall. No one knows how long that recovery will take.

Some banks have so many “toxic” assets that they don’t have enough capital to cover losses in the worst-case economic scenario. That’s forcing some banks to hoard cash that would otherwise be used to make new loans, which in turn would help spur business and create jobs.

To shore the banks up, the Treasury last fall swapped roughly $200 billion in cash for a special interest-bearing stock in the biggest and most troubled banks. Regulators then set about trying to find out exactly how much capital the 19 largest banks would need to weather a rough economic storm.

After meticulously analyzing the impact of a deeper recession on these risky bank assets, the Treasury is now telling about half of those banks they need to raise more capital. Published reports indicate that Bank of America, Wells Fargo and Citibank are among those being told to add tens of billions to their capital cushion.

These banks have two choices to bolster their capital. First, they can sell assets or issue more common stock on their own. The Treasury is giving them a deadline of six months to raise the money. If they can’t raise the capital, the Treasury says it will step in with Plan B, which involves converting the government's special preferred shares into common stock, effectively taking partial ownership of the weakest banks.

But as the government singles out which banks need more capital, it risks making it harder — and more expensive — for those banks to raise the money they need.

“For the shareholders of Wells Fargo or Bank of America, I think it's an outrage,” said Frederick Lane, a Boston-based investment banker. “What's happening, of course, if equity needs to be raised, it's going to be raised under perceived duress. Having these banks sell into a firestorm is difficult.”

Bank stocks have gotten pummeled since the financial crisis began last year, losing more than half their value overall. Bank of America and Citigroup, among the hardest hit, have seen their stock prices collapse by more than 90 percent. That makes it even harder to raise capital by selling fresh stock; the more new shares they sell, the less each share will be worth. (That’s because issuing new stock dilutes the ownership of existing shareholders.)

Some have argued that the “stress test” wasn’t needed in the first place. Private institutional investors do their own analysis of banks’ book before deciding whether to buy shares. Bank regulators routinely review the books of individual banks and require them to keep a minimum level of reserves on hand.

“They're called bank examinations and that's what these should have been,” said Fine. “And you don't make bank examinations public. There's a reason for that. And we're seeing the reason for that and the reactions to the market.”

That’s touched a debate among investors and regulators over whether it was such a great idea to disclose the results of the stress tests in the first place. Some analysts say the results may make it even harder for banks tagged as short on capital to sell new stock at any price.

“Finding news investors (will be difficult) given that financials have remained very much an out of favor sector,” said Alistair Scarff, head of Asia financial institutions research at Bank of America Securities. “Recent numbers have suggested they’re among the most shorted stock on the Street. So trying to find new appetite is going to be a challenge.”

It has also separated banks into two categories: those that need more capital (and possibly more government help) and those that don’t. The Treasury insists that no bank will be allowed to fail, which means the weaker banks can count on the government to prop them up. That could make life difficult for the healthy banks, much the way an airline in bankruptcy can cut ticket prices forcing healthy competitors to match them.

“This is one of the things I think the healthy banks risk,” said Peter Sorrentino, a portfolio manager at Huntington Asset Advisors. “If you have a competitor operating under protection, they can behave irrationally, they can impact pricing, impact policy decisions — all to your detriment. In effect, you want a level playing field as rapidly as possible. Otherwise, it brings down the health of the entire industry.”

Healthy banks may also find themselves at a disadvantage when they try to give the government’s money back and reclaim the preferred stock they issued. Treasury officials are reportedly considering a provision that would remove FDIC loan guarantees for banks that opt to pay the Treasury back. By lowering lending risk, those guarantees have helped lower the cost of borrowing for banks.

Ultimately, the most powerful tool for restoring bank capital is the Fed’s “zero interest rate” policy. By essentially eliminating the cost of short-term borrowing, the Fed has produced a huge profit stream for the banking industry. If you’re a bank borrowing at zero and lending at 4 or 5 percent, it’s pretty hard not to make money.

As a result, banks like Bank of America and Citigroup have been generating huge piles of cash in the last few months. In some cases, they’ve been able to build capital faster than the Treasury expected when it first pumped capital into the system last fall.

“With Bank of America, that's a powerful economic engine,” said Donald Powell, former FDIC chairman. “Something like five out of ten people have some type of relationship with Bank of America. That's an earning machine.”

But banks are by no means out of the woods. A lot depends on whether the economy continues to stabilize. That has some investors taking a closer look at the assumptions used in the stress test’s “worst-case” economic scenario, which forecasts an unemployment rate of 10 percent by the end of next year.

“It’s our house view that we’ll see a 10 percent unemployment rate by the end of this year,” said Scarff. “Numbers at some of the banks I speak to are pointing to a 12, 13 percent rate. So it could actually be a softer-than-worst-case scenario expected in these stress tests.”

All of which will depend on the ultimate goal of the bank bailout — to get more lending moving through the economy. If banks can’t find more capital, or continue to rely on government support, that could continue to restrict lending. Despite recent signs of improvement in the economy, a prolonged recovery will depend on getting the banking system back on its feet as quickly as possible.

“Things are still quite fragile,” said former Federal Reserve Board Governor Randall Kroszner. “We're not sure we're there yet. Everything is really contingent upon making sure the banking system is stabilized.”

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