Big Banks Seek Better Scores on Stress Tests

As executives of the nation's largest banks review their stress-test results, even the top performers are lobbying regulators to raise their scores before the numbers are finalized Friday.

Any banks found to need more capital face tough choices that would hurt shareholders and put taxpayer money at greater risk.

The Federal Reserve on Friday privately gave the 19 largest financial firms preliminary results of tests designed to see how they would withstand a harsher recession.

Executives sifted through the data over the weekend, devising arguments they hope will persuade regulators to boost their scores, according to two industry officials who requested anonymity because regulators have barred them from discussing the process.

Banks have until Tuesday to make their cases. They will receive the final test results Friday, and the information will be released publicly May 4.

The results will determine the fates of the companies, which together hold one-half of the U.S. banking system's loans.

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Banks found to need more capital face several possibilities: The government could convert its stake in them to common shares, force them to raise money from investors or eventually release more funds from the Treasury Department's $700 billion financial bailout.

For Treasury, the easiest way to bolster bank balance sheets is to convert the government's existing stake from preferred shares—a form of debt—into common shares that carry voting rights.

This would help Treasury avoid returning to Congress for more bailout money—a request lawmakers are likely to rebuff.

The banks' options are designed to ensure banks have enough cash to withstand the mounting loan losses they would absorb in a bleaker economy.

If the test showed a bank would need more money to endure a much worse recession, regulators will force it to meet higher standards for capital reserves, to offset possible future losses.

Banks deemed to have enough capital may learn whether they'll be permitted to repay billions of dollars the government injected into them last fall, analysts and officials said.

Most large banks have said they want to repay the money to escape executive compensation limits and other obligations.

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Investors have grown more concerned about regional banks with many risky loans on their books.

Defaults on those loans could skyrocket in a worsening economy. Banks that carry such loans are likely to be asked to improve their capital reserves.

Construction loans would lose up to 18 percent of their value in two years under the stress-test scenario outlined in a confidential Fed document obtained by The Associated Press.

Troubled banks—those that need larger buffers—have no good options, said Karen Shaw Petrou, managing partner at Federal Financial Analytics, a consulting firm.

"They don't want to do any of this," Petrou said, because banks think they can make smarter business decisions when the government doesn't intervene.

Those who favor converting the government's loans into common shares say it would help banks by giving them capital that investors regard as better evidence of financial strength.

Paul Miller, an analyst with Friedman, Billings, Ramsey & Co., said the strategy is essential to stabilizing the banks.

He said forcing companies to carry more common equity would improve market confidence.

"It's meaningful, and it needs to be done now," Miller said.

But the move would place billions of taxpayer dollars at greater risk. The value of Treasury's shares would rise and fall with the markets and could disappear entirely.

Shareholders, already skittish about the government's role in the banking industry, would see their stakes diluted: Every existing share would account for a smaller portion of the company.

"It's disastrous for shareholders," Petrou said. "It also creates a very uncomfortable form of corporate governance, having the government as a voting shareholder."

Critics say giving the government a bigger stake amounts to a backdoor nationalization of the industry.

Some dismiss the move as mere accounting sleight of hand that won't make a real difference.

"You can describe capital in different categories, but it doesn't change the actual capital," said Christopher Whalen, managing director of the consulting firm Institutional Risk Analytics.

Whalen said he opposes converting the government's money to common stock because it doesn't address the banks' even greater reliance on trillions of dollars in loan guarantees and other government subsidies outside the $700 billion bailout.

Banks forced to raise private money could have trouble finding investors or could face inflated interest rates, because markets will know the government said they needed more capital.

But that, too, would help Treasury conserve what's left of its bailout fund.

Speaking Monday to the Economic Club of New York, Federal Deposit Insurance Chairman Sheila Bair suggested it won't be necessary to ask Congress for additional bailout funds in the immediate future.

"I do believe the current resources of the Treasury will be sufficient," Bair said. "For now, we have the resources that we need."

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