What The Bank Stress Test Conceals!

In order to restore public confidence in the health of the U.S. banking system,the Fed decided to put nineteen of the biggest banks,each with assets of over $100 billion, through a 'stress test.' Since these banks together form about 65% of the U.S. banking system, it was felt that maintaining their health was of utmost importance in order to protect the entire banking system.Though the idea was conceived way back in September of last year it was implemented now.

The Fed's anxiety is reflected in the way this test was conducted.Discussions with the banks resulted in a more lenient test than originally planned and the results were 'leaked' a few days in advance. The official results showed that nine banks passed the test and would not need to raise any additional capital.The remaining ten banks would need to raise about $75 billion of additional capital which is lower than expected.

Even before the results were announced banks had announced their first quarter results for this fiscal which beat street estimates.But the real picture is not as rosy as it appears at first sight.Banks at the moment have borrowing costs which are close to zero.Additionally, due to changes in mark-to-market accounting rules by the FASB they are managing to avoid making write downs in the values of their loan portfolios.This also allows lower provisioning for future loan losses. Make no mistake, such losses are going to be substantial.Residential housing prices have still to hit bottom and the meltdown in commercial real estate prices has just begun. Rising unemployment is bound to increase credit card delinquencies.

Although banks are finding it very profitable to make new loans as the cost of borrowing is virtually zero, the stress test is silent about as to how these banks will go about repairing their damaged balance sheets. The visible options are that either the banks will raise more capital from private investors or the government will convert preferred shares into common stock. In all probability some mixture of the two alternatives will be pursued though it will dilute the value of the stocks held by present investors. Finally the test tells nothing about how the banking system is going to rid itself of the 'toxic assets' that continue to haunt these banks.All in all the banks continue to be weak and a lot of uncertainty still lies ahead.