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A guide to how banks’ stress tests work

After weeks of speculation, regulators led by the Federal Reserve are telling banks how they fared in the "stress tests" at the center of the Obama administration's financial rescue plan.
/ Source: The Associated Press

After weeks of speculation, regulators led by the Federal Reserve are telling banks how they fared in the "stress tests" at the center of the Obama administration's financial rescue plan.

Markets rallied and investors breathed a little easier Friday after a Fed news release on the methods underlying the stress tests. But the white paper, which one former bank examiner for the Fed called "not for mass consumption," left lay people wondering what it all means.

Here are a few questions and answers about the stress test's methods and the next steps for shoring up the financial system.

Q: What is this "stress test"?

A: The "stress test" is actually two tests measuring how much value banks' assets — loans it's made along with various other investments — would lose over the next two years under different economic scenarios.

The first scenario was based on predictions about the current recession. It assumed unemployment will reach 8.8 percent in 2010 and house prices will decline by 14 percent this year. The second scenario was for a worse-than-expected downturn. It said unemployment will reach 10.3 percent in 2010 and house prices will drop by 22 percent this year.

After testing banks' assets to see how much value they could lose, officials compared the losses to the banks' capital cushions — basically, the money they've got in reserve — to see if the banks could survive a bad recession.

Q: Who participated?

A: The tests were run on 19 large bank holding companies, including an insurer, an auto finance company, a credit card company and banks ranging from massive Wall Street houses like Citigroup to regional banks like KeyCorp and PNC Financial Services. The banks all have $100 billion in assets, and together hold half the loans in the U.S. banking system and two-thirds of the assets, according to the Fed.

The tests were performed by the banks' regulators, including the Federal Reserve banks, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency.

In case you're curious, here's a full list of the Big 19: JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp., Wells Fargo & Co., Goldman Sachs Group Inc., Morgan Stanley, MetLife Inc., PNC Financial Services Group Inc., U.S. Bancorp, Bank of New York Mellon Corp., GMAC LLC, SunTrust Banks Inc., State Street Corp., Capital One Financial Corp., BB&T Corp., Regions Financial Corp., American Express Co., Fifth Third Bancorp and KeyCorp.

Q: What did the regulators find out?

A: Specifically, we don't know.

In general, they said most banks are well capitalized and won't need more help. But since they will be holding banks to a higher standard in light of the rough economy, they will take preventive steps for some banks.

If a bank looks too weak to handle a steep recession, regulators will convert the bailout money into common shares — the kind most investors buy and sell on major exchanges — and could give the companies more bailout money or force them to raise more money in the private market.

Q: Does that mean we're safe?

A: The Fed sure hopes so.

Their goal is to build confidence in the financial system, and to prevent bank problems from spilling over into the broader economy.

But the truth is, we just don't know. Larger credit problems or a severe downturn still could threaten these banks, especially regional banks that own a lot of risky mortgages. If the banks go down, the government may have to spend more money forcing them to merge — and that could set off a whole new cycle of uncertainty.

Q: Does that mean we're staying on the bailout train?

A: For the foreseeable future. Regulators have decided these banks are "too big to fail." In other words, their failures could wreak havoc on the financial system, like what happened last fall when Lehman Bros. declared bankruptcy. By all indications, the Fed is ready to do whatever it takes to make sure that doesn't happen again.

Q: So what's next?

A: Banks will spend the weekend poring over the results regulators revealed to them today. If they see something they don't agree with, they can appeal the government's determination. Next Friday, they will receive the final word on what the government wants from them. And on Monday, May 4, there will be an official announcement about the outcomes.

No one knows exactly how detailed that statement will be. But when a reporter asked about it in a briefing Friday afternoon, White House spokesman Robert Gibbs said, "Our strong inclination is to provide transparency."