The Obama administration may direct banks that are judged to be short of capital after stress tests to disclose how they are going to get additional funds when the government reveals the results on May 4, according to a person familiar with the matter.
The government would release a bank-by-bank assessment, while the lenders would say how they plan to shore up their finances, said the person, who spoke on condition of anonymity because a decision hasn’t been made....
The Treasury and banking regulators are still working out the final details of how to reveal the test results and plans could change, said the person. Generally, the regulators favor less disclosure because bank exam data is confidential, while the Treasury advocates releasing more details....
Regulators conducting the stress tests are increasingly focusing on the quality of loans banks made after finding wide variations in underwriting standards, a regulatory official said on April 20. They concluded that banks’ lending practices need to be given as much weight as macroeconomic scenarios in determining the health of each bank, the person said.
May 4th is going to be a big day. The banks that don't pass the tests will probably get killed. I don't think the failing banks will be able to raise capital, unless it is backed by the government or something. Even then, I can't see anyone wanting to invest in equity given the risk of future losses (unaccounted for by the stress test.)
Initial leaks--one has to assume these are strategic leaks by the government--seemed to suggest that the stress was to use a mild assumptions. This would have meant that nearly all the banks may have passed. Later on, the government, through media leaks, seemed to indicate that they will be using more stringent tests. In this latter scenario, it is possible that some major banks won't pass or will barely pass.
The stock market will probably struggle in the short term, after the results are announced, given how most of the insolvency concern surrounds the megabanks and they are the ones with the largest weight in the stock indexes (although their weight has declined significantly over the last 2 years.) However, I believe that transparency will help in the long run.
My confidence in my understanding of the banking situation has deteriorated. Although I never invested in any bank, I have been completely wrong with my early views. For instance, I never realized how bad Merrill Lynch was, and hence underestimated the severe damaged it caused Bank of America; or how bad Wells Fargo may be if the bears are to be believed. My initial view was the banks were facing liquidity problems but I think Nouriel Roubini (and others) are correct in saying that we are looking at insolvency. Not every bank is insolvent but major ones are insolvent enough to cause serious problems. John Hampton at Bronte Capital has suggested that American banks, as opposed to say British ones, can earn their way back but I don't share that view anymore. The potential losses look so large--it's incomprehensible to me anymore--that it could take 10 to 20 years to cover their losses and pay out reasonable dividends to shareholders (otherwise the banks are near worthless, no?) To make matters worse, there is a possibility that we have seen the end of financial revolution and financial profits will contract going forward. If it took, say, 8 years for an insolvent bank from the S&L crisis to earn its way back, now it might take 15 years.
Having said all that, if you are a contrarian and have a good sense of losses and future profitability then financial stocks are worth investigating.