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Can Your Bank Pass the Stress Test?

8 minute read
Stephen Gandel

For months, customers and investors have wondered if their banks will survive. The government may soon give its opinion. But don’t be surprised if you find the answer inconclusive.

In early February, Treasury Secretary Timothy Geithner, as part of his bank fix, said he will “stress-test” the nation’s largest financial firms to find out which ones are fit and which ones are flatlining, and then apply the appropriate therapy–which we assume means anything from injecting capital to pulling the plug. By using a medical term, Geithner gave the impression that he had some fiscal electrocardiograph that could be strapped to banks to chart the strength of their accounts. But when it comes to a bank checkup, the actual test is far less scientific.

In theory, a financial stress test looks at a firm’s loans, assesses which will go bad and then concludes whether the bank will have money left when those accounts go unpaid. Pretty clear.

But in reality, to run the test, you have to guess not just which borrowers will stop paying but also when. Some losses will be covered by profits elsewhere. So the firm’s bottom line must be estimated. The variables leave plenty of room for the government to make some banks look better or worse, depending on the assumptions it makes. Not so cut and dried.

Geithner hasn’t detailed his test, other than that it won’t be complete for another month. Worse, officials at the Treasury say the tests probably won’t be made public. That will sort out the uncertainty that has driven the stock market down, won’t it?

So instead of waiting around for the government’s finger-in-the-air results, TIME decided to poke and prod the banks on its own.

To do so, we relied on the loan-loss estimates of New York University professor Nouriel Roubini, a.k.a. Dr. Doom, who has been sagelike in his predictions about the credit crisis so far. We factored in the banks’ results this year, as projected by Wall Street analysts. Besides the hit that banks will take for soured loans, the firms also have losses in their investment accounts. But since markets go up as well as down, we stuck to the actual cost of their lending foibles rather than guess where the market for debt is headed next.

The exception is Citigroup. Since the bank struck a deal with the government to shield $301 billion in losses, we had to account for some investment missteps to value the arrangement. Bank of America has a similar deal, but since the details aren’t public, we didn’t factor it in.

Any stress test is also influenced by the measure you use. We chose the leverage ratio. To calculate it, divide a bank’s equity by its assets, much of which are loans. The lower this ratio goes, the shakier a bank becomes. For example, a 10% leverage ratio means the bank has lent out $10 for every $1 in equity it has. A 5% reading translates to $20 out for every $1 in hand. Regulators like to see a reading of at least 5%. Anything less than that and a bank could become toast. Here’s what we found:


Loan losses: Even after making a government deal, the bank is still on the hook for the first $40 billion in loan losses in the pool it has insured. Citi also has $277 billion in other, nonhousing consumer loans, such as credit cards and student debt. Roubini estimates that about 17% of consumer loans will go unpaid nationwide. That translates into a $47 billion river of red ink. Add in everything else (commercial real estate, corporate loans), and Citigroup will have to swallow $106 billion in loan losses by the end of 2010.

Capital cushion: Thanks to the Troubled Asset Relief Program (TARP), Citigroup now has $151 billion in equity, up from $113 billion a year ago. Alas, it will have a $76 billion hit from bad loans. Along with a projected bottom-line loss of $3.5 billion, that drops the bank’s capital to $70.5 billion.

Prognosis: On the way to the ICU. Citigroup has a projected leverage ratio of just 3.8%–far lower than what it would need to be considered well capitalized. How much would the U.S. have to give the bank to nurse it back to good health? About $22 billion.

JPMorgan Chase

Loan losses: JPMorgan largely avoided the troubled subprime-lending game. Not so Washington Mutual, which JPMorgan acquired in 2008 in an FDIC-brokered deal. With housing prices still falling, many of those WaMu loans are going unpaid. JPMorgan has $105 billion in credit card loans, which could cost the company some $18 billion. And there is an additional $262 billion in corporate and commercial loans, which, according to Roubini, could tally $26 billion more in red ink. All told, it’s a $97 billion loss for JPMorgan.

Capital cushion: JPMorgan has $23 billion in its rainy-day fund for such losses. Not enough. Shareholders’ equity will drop to $121 billion, from the current $167 billion.

Prognosis: Looking good. JPMorgan is in better shape than other big banks are. Its post-test leverage ratio drops to 6.4%, from nearly 8%–still a picture of financial health.

Bank of America

Loan losses: BofA’s buyout of mortgage broker Countrywide means the bank has $400 billion in home loans outstanding–more than its competitors. Worse, Countrywide, by nearly all accounts, had shockingly low lending standards. Chalk up a higher-than-average $40 billion in losses there. On top of that, BofA has made $87 billion in loans to commercial real estate developers. Roubini predicts 17% of those loans will go bad as developers hit the skids. For BofA, that’s $15 billion more in losses. Toss in $55 billion in commercial- and consumer-loan losses, and you get $121 billion in lending deficits by the end of 2010.

Capital cushion: BofA has put away $23 billion to cover future losses, and it has more equity–$177 billion–than JPMorgan or Citigroup. But that might not be enough to preserve it without government help.

Prognosis: Prepare the transfusion. BofA is still on the monitor, but it’s not far from being healthy again. It has a stressed leverage ratio of 4.6%. Just $7.3 billion in new capital would put BofA back on its feet. And with Uncle Sam finalizing its deal to guarantee $118 billion of BofA debt, the bank may already be on the mend.

Wells Fargo

Loan losses: When Wells Fargo acquired Wachovia late last year, it more than doubled its loan book. In good times, that would be a major coup. These days, it’s major trouble. Home buyers owe the bank $360 billion, up from about $150 billion just three months ago. Next, Wells has $154 billion in commercial real estate loans, as well as $200 billion in other types of commercial debt. Apply Roubini’s overall 13% loss projection, and the conclusion is that Wells may be sitting on a $117 billion loss.

Capital cushion: The good news for Wells is that it has been aggressive in identifying problem loans–$37 billion from Wachovia alone. Wells officials argue that will lead to lower losses than its competitors’. But if not, the bank could be in trouble.

Even after the $25 billion Wells got from the government last year, it has just under $100 billion in equity, trailing other major banks by more than 50%.

Prognosis: Defibrillator. Stat! Wells Fargo is generally considered one of the banks that are least likely to fail. But our stress test says otherwise. Even with its $58 billion loan-loss buffer, Wells is still in the hole for $59 billion, or 60% of its capital. With $40 billion remaining and an expected $5 billion in income, the bank could sink to a less-than-rosy leverage ratio of 3.7%.


Banks should show at least a 5% leverage ratio between equity and assets to be considered healthy. Here are two-year projected numbers for the four biggest banks:


[This article contains a table. Please see hardcopy of magazine or PDF.]

 NOW PROJ. 2010 ASSETS $2 trillion $1.9 trillion EQUITY $150 billion $70.5 billion RATIO 7.7% 3.8%

Citigroup looks sick. Will need $22 billion in additional capital

JPMorgan Chase

[This article contains a table. Please see hardcopy of magazine or PDF.]

 NOW 2010 ASSETS $2.1 trillion $2 trillion EQUITY $166 billion $128 billion RATIO 7.8% 6.4%

JPMorgan is fit and should stay that way

Bank of America

[This article contains a table. Please see hardcopy of magazine or PDF.]

 NOW 2010 ASSETS $2 trillion $1.8 trillion EQUITY $176 billion $84.3 billion RATIO 9.0% 4.6%

Bank of America will need $7 billion to maintain a clean bill of health


[This article contains a table. Please see hardcopy of magazine or PDF.]

 NOW 2010 ASSETS $1.3 trillion $1.2 trillion EQUITY $99 billion $44.5 billion RATIO 7.6% 3.7%

Wells Fargo will need $16 billion to be well again

Note: Figures exclude investment losses

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