Are you ready for the banking judgment day? Are you ready to see what happens to Bank of America (NYSE: BAC ) , Citigroup (NYSE: C ) , and Wells Fargo (NYSE: WFC ) when the iron fist of the government slams down?
The official name for the assessment is the Supervisory Capital Assessment Program, or SCAP, but we all know it simply as the "stress tests" (cue ominous music). Results of how the largest 19 U.S. banking institutions fared in this numerical gauntlet are scheduled to be released Thursday, and the market is waiting with bated breath.
So what are these stress tests all about? And, more importantly, what are they going to mean for banks like PNC Financial (NYSE: PNC ) , US Bancorp (NYSE: USB ) , and the other giants mentioned above? What will it mean for shareholders? I'm glad you asked. Consider this your stress test cram session.
Prepare to get stressed
Given the hundreds of billions of dollars that the government had to pump into the banking system to keep it from seizing up, it shouldn't be that surprising that it's a little concerned about how prepared the banks are for what is yet to come -- and that's where the stress tests come in.
The tests are a collaborative effort of organizations including the Federal Reserve, the Office of the Comptroller of the Currency, and the FDIC, and they are designed to look ahead to what kind of trouble the largest banks could run into.
To do this, the folks from the government cooked up two potential economic scenarios -- one it considered the most likely, and one that was more adverse -- and asked the banks involved in the tests to use the two scenarios to predict their income and losses through 2010.
The government used the banks' data to determine which would need additional capital to be secure through the end of next year.
The stressful diagnosis
While some of the results of the stress tests appear to have been leaked out, one of the big unknowns is how the government will go about releasing the results. It's been reiterated on a number of occasions that the tests are meant to be an indicator of which banks need an extra capital cushion -- not a condemnation of banks that have "failed."
For that reason, it's likely that the release of the results will be very carefully couched with encouraging language about the banking system. At the same time, those hoping for a big data dump detailing the innards of the tests should prepare themselves for disappointment.
Getting down to the specifics of what we've already heard, it sounds like 10 of the 19 banks tested may be lining up for a fresh dose of capital. The names tossed around in the dunce column include Bank of America and Citigroup, while many are assuming that JPMorgan Chase (NYSE: JPM ) and Goldman Sachs (NYSE: GS ) will be given a pass.
Treating the stress
The penance for banks deemed to have failed the stress tests is simple: Raise your capital level. This isn't the ideal situation for current shareholders, because new capital dilutes their ownership position -- and could bring other unsavory side effects.
Raising capital from the private market would be the most straightforward, and likely the most ideal. However, some of the more banged-up banks, like Citigroup, may have trouble doing a big private capital raise at all, and if they did, it would likely be massively dilutive.
On the other hand, taking more money from the government comes with the specter of more government meddling. Besides, with just $135 billion left in TARP funds, it's not clear that there would even be enough left to meet all the capital needs.
So a backdoor approach to meeting the increased capital requirements is expected from a lot of the banks. The banks in need of capital would convert the preferred shares that Uncle Sam bought through TARP into common shares, thereby raising the bank's common equity. If this seems like a little sleight of hand, it's because it is.
The switcheroo wouldn't actually inject any new capital, it would just change how the government's current investment functioned.
Instead of being interest-bearing shares that would mature and need to be paid back, the government's shares would now be noninterest-bearing equity that the bank could keep indefinitely. In situations where this process doesn't result in a satisfactory capital position, the conversion would probably be paired with additional capital from the private market or the government.
Bear in mind that it's not a free ride for the banks that do convert the government's preferred shares to common. Those new common shares would represent equity ownership in the bank and would come with voting rights, so the government would end up a major voting shareholder in a handful of banks.
Thursday's outlook for bank shares: Stay on your toes
As much as the stress tests are designed to legitimately test the capital needs of major banks, they're also designed to increase the public's faith in the banking system. The examiners have carefully thought about exactly how they're going to release these results so that they convey the bottom line capital needs without creating a panic around the institutions that failed the tests.
I see little likelihood that the actual results will send bank shares into a swoon. However, that doesn't mean that shareholders are in the clear. The approach to raising the needed capital could trip up the shares of some banks as investors digest the level of dilution and the potential for a stranglehold vote held by the government.
Additionally, there's the risk that investors won't believe they're getting the full story from regulators, and they could flee from the banks that failed for fear that they're in worse shape than the government is letting on.
Of course, it won't be until the rubber hits the road tomorrow that we'll see how the market reacts. But you can now consider yourself armed and ready to tackle the stress test results -- whatever they may be.
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