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Banking system still faces rough road ahead

Despite clear signs of improvement for the banking industry, the road ahead is still full of potential potholes – especially for weaker banks that still rely on the government for capital.

News that 10 big banks will repay $68 billion in government bailout funds is being hailed as a key milestone on the road to a recovery for the battered banking system. But despite clear signs of improvement, the road is still full of potential potholes — especially for weaker banks that haven’t been able to replace government-provided capital with private investment.

The banks, led by JPMorgan, Morgan Stanley and Goldman Sachs, got the green light Tuesday to hand the money back, after passing a government “stress test,” raising fresh capital and satisfying regulators that they’re strong enough to ride out the recession. Another nine large stress-tested banks are keeping the government funds for now, as are several hundred smaller banks that got so-called TARP funds.

But with unemployment rising and home prices falling, it’s not clear whether the stress test was stressful enough. Assumptions about the “worst case” economic scenario — made when the test was designed in February — turned out to be too optimistic, according to Elizabeth Warren, head of the Congressional Oversight Panel set up to oversee the bank bailout.

“We've already blown past the worst-case scenario on unemployment,” she said on CNBC this week. “That means it's time to rerun those numbers and find out if the stress test is strong enough to give us a  good prediction and tell us these financial institutions are solid even if unemployment is higher than the model predicted.”

Some of the biggest banks were reluctant to take government funding from the beginning and have chafed under restrictions on pay packages and other strings that came attached to the Treasury’s billions. Now, some observers fear the bankers may be too eager to get out from under the government’s support.

“I think it's way too premature,” said former Citigroup senior executive Carl Levinson. “I think the (banks’) first-quarter earnings were overstated through trading profits. And there’s nothing wrong with waiting at least another quarter — or maybe even two. Because the worst thing that can happen is a double-dip recession and we go back down again.”

To win Treasury permission to pay back funds from the Troubled Asset Relief Program, or TARP, the banks had to lay out a plan to show how they could raise enough money to rebuild their capital base. Much of that money is expected to come from bank profits, which were surprisingly strong in the first three months of 2009.

Though the economy is showing signs of bottoming, heavy losses on credit cards and commercial loans could continue to weigh on bank profits well into next year.

The TARP program has had only mixed success in its original intent: to free up credit and get banks lending again. Financial markets have stabilized since last September, and fears of a wider collapse have eased along with the cost of lending. And banks have raised more than  $100 billion in private capital so far this year to boost their capital base.

But lending activity is still below levels normally seen in a healthy economy.

"The lending capacity is there,” said Tom Brown, an industry analyst at “What is needed is the economy to continue to show signs of recovering and then business borrowing coming back.”

The TARP was originally created to buy bonds and other securities backed by mortgages that produced huge losses. But the Treasury couldn’t figure out how to value the assets because so many homeowners are continue to default on their mortgages.

Instead the government structured the bailout funding as a special preferred stock that could be switched into common — automatically by the government — if and when a bank’s capital fell below required minimums.

But the TARP funds did little to directly spur more lending — largely because banks have to pay 5 percent interest on the money.

“That  means they have to lend the  money at more than 7 percent pre-tax to break even,” said Richard Bove, an industry analyst with Rochdale Securities. “And they can't do that. It doesn't  make sense for these companies to hold on to TARP money because they can't make money.”

But nine big banks, including Citigroup, Bank of America and Wells Fargo, will have to hold onto their bailout funds until regulators say they’re strong enough to give it back. That raises the risk that investors, customers and other lenders may begin to shun those “bad” banks over concerns that they don’t have enough capital. Critics of the TARP program say it has done little to resolve the original problem: cleaning up the refuse from a wave of risky lending that produced huge losses.

“They’re zombie banks,” said Jim Rickards, former general counsel at Long Term Capital Management. “They should have never given them the TARP money in the first place."

Rickards said the government should have essentially taken over the "bad" banks in the fall, removed the bad assets and returned the "clean" banks to private hands.

Meanwhile these struggling big banks are creating problems for smaller banks trying to compete for borrowers with good credit and cash from depositors.

“There’s a lot to unfair competition out there from the zombie banks that offer CD rates that we can’t pay because they’re desperate,” said William Dunkelberg, chairman of New Jersey-based Liberty Bell Bank. “We can’t do that.”

Dunkelberg is also chief economist for the chief economist for the National Federation of Independent Business.

Obama administration officials say the $68 billion in bailout money being returned will go back the Treasury to help pay down the national debt. Treasury officials have said they plan to continue to provide TARP funds to smaller banks, although not those that are in imminent danger of failing.

The FDIC’s list of “problem” banks — those at risk of running out of capital — has risen to 305 since the banking crisis began last year, the highest level in 15 years.

“The community banks are still having trouble with raising capital," said Chris Cole, senior regulatory counsel at the Independent Community Bankers of America. “There really aren’t too many alternatives out there. So if a community bank wants extra capital, the government may be the only game in town for them.”

But some bankers are reluctant to take TARP funding for the same reason big banks want to pay it back.

"The way the Treasury Department has handled this program they keep changing the rules every two to three weeks," said Tom Brown, an analyst at "So we really don't know how restrictive it's going to be for the banks to continue to have TARP funding.”