Uncertainty over bank stress testing and the
billions in loan losses the institutions will have
to cover poses a threat to the stock market rally.
Results of the tests are scheduled for
release Thursday, and some analysts suspect
that the numbers could trigger a leg down for a
market that has used strength in financial stocks to
pave the for an eight-week run higher.
"My sense is we have a disconnect between the
hopes and expectations on Wall Street and the
reality on the ground," said Martin Weiss,
president of Weiss Research and a persistent critic
of the stress testing process as implemented by the
government.
As written, the current process takes only a
slightly worse-than-consensus look at what
economists think will happen and not a worst-case
scenario typical of bank stress testing, Weiss says.
A true testing would show that six of the
nation's 19 largest bank--the pool being used for
the stress tests--are in real danger of failing,
Weiss said, listing those as JPMorgan Chase, Goldman
Sachs, Citigroup, Wells Fargo, Sun Trust and HSBC.
Yet even with what Weiss considers lower
standards many of the banks will remain in trouble,
and investors are certain to take notice.
"Overall I believe that the consensus will
be that too many large banks are not coming out well
in the stress tests, and if the tests were
adequately severe ... there would be even more
institutions that will fail the tests," he
said. "I think that would trigger another big
decline on the financial stocks. I don't know if it
will happen immediately, but I see a major decline
in financial stocks."
Standard & Poor's has conducted its own round
of stress testing and predicts major shifts in the
industry due to the billions that banks will need to
be made whole again.
Reflecting concerns over the criteria the
government is using, S&P applied standards that
were more strenuous and based on economic realities
not seen since World War II, said S&P credit
analyst Tanya Azarchs. S&P says current bank
ratings probably don't reflect the conditions that
were expected and need to be changed.
"The market was thrown off by the economic
assumptions that the Fed laid out for the groundwork
of how the banks should think about the stresses
that they perform," Azarchs said. "We now
think the cycle is going to be much more severe. So
that is not discounted in the ratings and that means
we think that loss rates for any given loan category
will likely be higher than they have been in living
memory."
Whether any banks fail depends on a number of
factors, including just how aggressive the
government plans on getting to save the large
institutions.
Banks who don't have enough capital on hand to
cover their losses will have to time to raise it,
but face a difficult environment in which to do so.
"If the market begins to think that a bank
needs to raise a significant amount of capital and
they can't do it--certainly in this market it's
difficult to raise any privately--we get the crisis
of confidence that forces in a liquidity
problem," Azarchs said. "That could cause
a run on the bank either from institutional
investors or depositors. That forces the bank to be
closed. That scenario is really hard to foretell
because of the question of psychology."
For the market, then, decisions will be based
primarily how well banks can convince investors that
they can cover their losses.
"There are a lot of moving pieces here. What
we have found is the loss rates are already
approaching previous highs," Azarchs said.
"The economy is still deteriorating, the
unemployment rate is still going up and we haven't
neared the end of it. So we can only surmise it's
going to be a whole lot worse than anything we've
seen since World War II."
How Hard of a Hit?
Other analysts have concerns as well.
The delay in releasing the results from Monday to
Thursday is just the latest blip in the process but
one raising the hackles of those already suspicious
of the tests' ability to accurately read bank
health.
The delay in releasing the results has cause the
situation to go "from the state of farce to
tragicomedy," said Richard Bove, analyst at
Rochdale Securities.
Bove sees mid-sized regional banks coming under
pressure as well from the tests, even though they
aren't included, as confidence wanes in the
industry. As many as 150 mid-sized regionals could
fail by the end of the year while mergers also will
abound for regional banks in Florida, the Midwest
and the Pacific Northwest, he added.
Even banks that won't fold also will be pressured
and could see their stocks hit.
Merrill Lynch issued a warning about several
large institutions involved with the tests, cutting
profit estimates for Bank of America (NYSE:BAC
- News),
Citi, Sun Trust, US Bancorp (NYSE:USB
- News)
and Wells Fargo.
However, Merrill added that BofA and US Bancorp
ought to be OK for the long run.
"We expect Bank of America to recover and
outperform longer-term but, similar to peers, the
stock could remain volatile near term due to sharply
rising credit losses and concerns about stress tests
and capital," said a report Merrill issued.
"We think U.S. Bancorp is better positioned
than peers to withstand the current cycle and stress
tests, despite rising credit losses," the
report continued. "We expect U.S. Bancorp to
continue to trade at a substantial premium to peers
as a flight-to-quality bank due to better credit
performance and lower capital markets risk."
Maybe Not That Bad
Market optimists believe the release of the
stress test results could be a non-event for several
reasons.
Initially the Obama administration wanted to keep
the test results private, reasoning that if word got
out that individual institutions came out poorly it
could trigger a run on those banks. Since then, the
administration has relented and agreed to release
the results, though some confusion remains over just
how detailed the data will be.
The most recent statements from the
administration indicate that the data will be fairly
complete both on individual institutions and on the
19 banks as a whole.
That has some hoping that the test results at
least aren't bad enough to cause panic among
investors.
"My guess is that the people in the
administration are smart enough that they would not
set the stage for an event that could derail either
the stock market recovery or economy recovery by
putting out confidence-breaking bad news," says
Peter J. Tanous, president and director of Lynx
Investment Advisory in Washington, D.C.
"It would seem stupid," he adds,
"for the administration to announce that it's
going to do these tests and reveal their results
without having a clue as to what those results could
look like and what effect they could have on the
markets."
Moreover, the market may not even be that focused
on financials anymore after the sector has been
beaten down so badly over the past two years, said
Peter Miralles, president of Atlanta Wealth
Consultants.
"The market is not taking its cues from
what's going on in the banking system right
now," Miralles said. "The market is taking
its cue from other businesses that are doing
well."
--Reuters contributed to this report.
