Stress Tests Reveal: Banks Need More Money!

We at Invest With An Edge have been dubious about the Treasury’s so-called ’stress tests” on the country’s 19 largest banks.  The testing is now complete and the banks have been informed of the results.  The public has not – though some details are leaking out.  As expected, it appears no bank will fail the test.  Some, however, will get a less-than-passing grade and face certain consequences.

Today the Wall Street Journal reported that Bank of America (BAC) and Citigroup (C) will be “asked” to bolster their respective capital bases.  A research report from Friedman Billings Ramsey estimates that Bank of America needs $60-$70 billion to restore its financial health. We won’t be surprised it Citi needs at least that much, and some smaller banks will probably need more capital as well.

Where, one might ask, will this new capital come from?  Private investors are not presently inclined to invest the amounts that will be necessary.  The $700 billion in the TARP program is almost gone.  Congress is in no mood to approve any more bailout money.  I see two other options.

One option is to convert preferred shares into common stock.  This has two benefits for the banks.  First, it eliminates the need to pay dividends to the preferred shareholders.  Second, it adds capital to the balance sheet without the need to raise any new cash.  If you’re not familiar with corporate accounting, this may sound strange, but its true.  Certain ratios of capital strength will be bolstered just be reclassifying shares that are already outstanding.  If you happen to be one of those shareholders who was counting on a dividend, you will not be pleased.

The other method may be used in combination with the first.  The Federal Reserve can print all the money it wants without asking anyone’s permission, a power enthusiastically embraced by Ben Bernanke in recent months.  Don’t be surprised if the Fed dips into its balance sheet to keep Citi and BAC afloat.

My personal preference is that insolvent banks be liquidated in an orderly fashion.  This is why we have FDIC and bankruptcy courts.  For whatever reason, the Obama administration and the Bush administration before it decided not to go that route.  They appear to believe that if they can just prop up the banks long enough, the economy will bounce back and solve the problems painlessly.

Maybe they’re right.  It’s a big gamble; if they are wrong, we will face years of stagflation.  But at least we’ll have zombie banks in which to store what little cash is left.  Congratulations.