Questions About Bank Stress Tests

Bank of America, Citigroup Told to Boost Capital as Validity of Bank Stress Tests Is Called Into Question

Bank of America Corp. (BAC) and Citigroup Inc. (C) were told by federal regulators to raise more capital after government "stress tests" revealed that the banks were not adequately protected against additional deterioration in the economy, published reports said yesterday.

Officials insist that neither Bank of America nor Citigroup should be viewed as insolvent, but people familiar with the situation told The Wall Street Journal that the capital shortfall amounts to billions of dollars at BofA. It is not clear how much of a shortfall Citigroup faces.

Analysts anticipate that some regional banks also will be required to raise more capital.

Banks that need more capital will have six months to accumulate the additional infusions by selling assets, selling more shares, or converting preferred government shares into common stock. If they are unable to build their capital through public and private sectors, the banks may again dip into taxpayer-funded government coffers.

Bank of America and Citigroup have received a combined $95 billion in taxpayer infusions, as well as hundreds of billions of dollars in government guarantees on bad, or "toxic," assets.

The government may become Citi's largest shareholder as soon as next month when the bank converts as much as $52 billion in preferred stock into common shares.

If the banks are forced to take on more government funding, top executives at both BofA and Citi could be forced to resign. Citigroup Chief Executive Officer Vikram Pandit and the bank's board of directors faced the ire of shareholders at the company's annual meeting last week. But even as tensions flared, efforts to oust the management fell flat, as 10 incoming members of the company's board, some of whom have been in place for two decades, were affirmed by shareholder votes.

Top-tier executives at Bank of America may not be so fortunate. BofA shareholders today (Wednesday) will decide the fate of Chairman and CEO Kenneth Lewis. Lewis has come under fire for the company's acquisition of Merrill Lynch & Co. Inc. (SQD) last year. Merrill Lynch lost $15.84 billion in the fourth quarter of 2008, contributing to a $1.79 billion loss at BofA and forcing the bank to seek out more government assistance.

"The same directors and management that entered the Merrill deal are still there, and we think they destroyed shareholder value on a permanent basis," Jon Finger, whose Houston-based investment firm is urging votes against Lewis and lead director Temple Sloan, told the Charlotte Observer.

For his part, CEO Lewis testified before New York's attorney general that Federal Reserve Chairman Ben S. Bernanke and former Treasury Secretary Henry M. Paulson Jr. pressured him to move ahead with the merger despite his reservations - while also keeping quiet about mounting losses at the crumbling investment bank.

"I can't recall if he said, 'We would remove the board and management if you called it [off],' or if he said, 'we would do it if you intended to.' I don't remember which one it was," Lewis said, referring to a conversation he had with Paulson. "I said, 'Hank, let's de-escalate this for a while. Let me talk to our board.'"

Bank Stress Tests Called Into Question

Both Bank of America and Citigroup objected to the preliminary findings by the government. Citi, in particular, has expressed frustration with the investigation into its finances.

The regulators are asking "a million questions" and it's "very unclear what they're aiming at," a senior executive told The Journal. "We can't discern a pattern."

Executives who met with regulators at the New York Federal Reserve headquarters on Friday, when the banks were first made aware that they would probably be asked to raise more capital, say they still don't understand the government's methodology.

The Journal cited people familiar with the matter as saying Citi wants to get credit for its recent effort to unload such businesses as Smith Barney and Nikko Cordial Services, the bank's Japanese brokerage arm. While these businesses have not yet been offloaded, they're expected to boost Citigroup's capital levels.

Citi also has concerns about the assumptions used by the Fed in projecting future losses and revenue.

Citigroup executives aren't the only ones questioning the Fed's methodology, either.

Elizabeth Warren, who chairs the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP), is just as confused as the Citigroup execs.

"I had believed that we would receive a much more detailed description of the stress tests last Friday," Warren, who is known as the TARP watchdog, said Monday at the Reuters Global Financial Regulation Summit.

Unlike Citigroup, however, Warren said that one of her main concerns is that the stress tests being applied by regulators are not stressful enough.

Calling the adverse scenario used to test the banks' health "disturbingly close" to current economic conditions, Warren sparked concern that a second round of tests might be needed.

"The stress tests will make a terrific contribution if they are tough and transparent," she said. "If they are not, they will be useless."

The fear that the stress tests are causing more harm and doing more to detract from investor confidence than to inspire it has been an underlying theme of the government plan.

Analysts speculate if government officials - under fire for not being more forthcoming about the details of their evaluations - were to release the methodology of the stress tests, analysts would compare that test criteria to public financial data and start to draw their own conclusions about which banks are likely to fail or will require additional infusions of capital.

"They've gotten themselves in a pickle on this thing," Bert Ely, an independent banking analyst told The Los Angeles Times. "It's clear they didn't think through how this was going to play out."

The results of the test were initially scheduled for release on Monday, but the government has since said the results will be released later in the week.

[Editor's Note: Money Morning Contributing Editor Shah Gilani, a retired hedge-fund manager and a recognized expert on the global credit crisis.]