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For bank customers, a guide to 'stress tests'

The “stress tests” for banks are over. The results have been made public. For some of us, the stress may just be starting.

While the goal of the months-long exercise was to calm fears of another big bank failure, it may end up doing the opposite.

Of the 19 banks on the list, 10 were told they had to raise a a total of $75  billion in new capital to shore up their ability to withstand continued losses from loans and investments that are expected to go bad.

Regulators told giant Bank of America it needs to raise $34 billion. Citigroup needs $5 billion. Auto and mortgage lender GMAC LLC needs $11.5 billion. Wells Fargo needs $13.7 billion. Morgan Stanley needs $1.8 billion. Regions Financial Corp. needs $2.5 billion.

Those that “passed” the test and won’t need to raise more capital include Bank of New York Mellon, American Express Co., Capital One Financial, Goldman Sachs, JPMorgan Chase and MetLife, according to the Treasury.

Here’s what the results of the test will mean for businesses, investors and consumers:

What did the bank “stress test” measure?

Bank accounting has some fairly complex twists and turns, but the basic question on the test was pretty simple: Will banks have enough money after the punishing losses they suffered since the housing market collapsed to weather the expected losses that lie ahead? Analyzing the pieces of that puzzle is complicated, but the overall math is straightforward.

Here's (roughly) how it works. Take the bank’s existing assets and then subtract a number representing all the shaky real estate loans and investments that probably won’t pay off. Now add back the profits the bank will probably make in the next six months. If the number is positive, the bank doesn’t need to raise more capital. If it’s negative, that’s the number the government says the bank needs to raise.

So how 'stressful' was the test?

That's where things get a little more complicated. The results depend heavily on the assumptions you use about the major variables in the formula. Not all bank assets are the same, for example. A big pile of cash in the vault is a better backstop against losses than a bunch of loans backed by declining real estate. Estimating which of those loans will go bad is more art than science and a lot depends on the assumptions you make about how quickly the economy will recover.

If a business isn’t paying off a loan on time, for example, that “bad” loan may turn out to be a good one if the economy recovers soon and the business gets back on its feet. A “good” home mortgage that’s still generating interest payments could quickly go “bad,” however, if the homeowner is laid off. Bank profits rely heavily on demand for loans: If the economy recovers and businesses start expanding again, loan demand should pick up.

How did the Treasury decide how much ‘stress’ to put banks through?

That’s not entirely clear, but some bank analysts think the test might not have been stressful enough to account for an extended recession. One key variable, for example, was the Treasury's unemployment forecast for the next two years. The more job losses, the worse banks will get hit. The Treasury’s “worst case” scenario assumed the unemployment rate will hit 10 percent by the end of next year. Many private forecasters think we’ll see that level by the end of this year, with job losses continuing and unemployment rising above 10 percent into 2010.

The test also made assumptions about how fast banks can generate fresh cash from profits over the next six months. The Treasury originally wanted to use 2008 revenues as a baseline. But after posting stronger-than-expected profits in the first quarter of this year, bankers reportedly convinced the Treasury to use those results and project them for the rest of 2009. If profits begin to sag later this year, the estimates of the banks’ capital shortfall could come up low.

So the banks that have to raise the most capital are in the worst shape, right?

Not necessarily. For starters, a lot depends on how big the bank is. A bank with $100 billion in assets that is told to raise $10 billion is in better shape than a bank with $20 billion in assets that needs to raise $5 billion.

Banks have several ways to raise the money, some more painful than others. They can sell assets, issue more stock or rely more heavily on profits. Different types of banking are generating different levels of profits, for example, so some banks are churning out fresh cash faster than others.

If my bank was told to raise capital, is my money safe?

Yes. For starters, the Federal Deposit Insurance Corp. has you covered up to $250,000 for each FDIC-insured account. (Investments such as stocks and bonds are not covered by the FDIC.)

The government also has said it will not allow any of the 19 banks it stressed-tested fail.  For the complete list, click here.

What if the banks that were told to raise capital can’t do so?

One possibility is that the government winds up owning some of their common stock, which means taxpayers become a partial owner. Few people — including bankers, Treasury officials or taxpayers — want that to happen. One solution would be to park a special “mandatory convertible” stock on the banks’ books until it gets its capital levels up to the required level. That would be converted to a government ownership stake only if losses come in worse than expected.

Does this mean the banks that “passed” the test are out of the woods?

Not yet. When the financial panic hit, one of the government backstops included loan guarantees for hundreds of billions in bank loans. This helped calm the financial markets and lowered the cost of borrowing. There are signs the markets are a lot less nervous than they were last fall. But the “good” banks will have to show that they can borrow successfully without those guarantees before they can pay back the government’s money and be done with the bailout.

It’s also not clear what the impact will be on “good” banks when — no longer relying on government help — they have to compete with “bad” banks that have been told the government won’t let them fail. If the "bad" banks rely more on government capital than on boosting profits, for example, that could make life tougher for everyone else. The “bad” bank could start offering higher interest rates to attract deposits, or cut rates on loans to generate business, forcing “good" banks to follow suit.

What about banks that aren’t on the “stress test” list?

Many of them are still eligible for help from the government if they run short of capital, but there is no guarantee the government won’t let them fail. Some smaller banks, especially those that invested heavily in commercial real estate, may not make it. If they do fail, they would most likely be taken over by the FDIC. That agency would pay off depositors, sell off the remaining assets, and make up any shortfall with money from the insurance fund supported by insurance premiums paid by banks in the FDIC system.