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B- for stress test

Wall Street Journal gave a B minus to government-led stress test on major banks:

The government's bank stress tests deserve a B-minus.

To give a sustained boost to investor confidence, the tests needed demonstrable rigor. They achieved that up to a point. While worst-case loss rates look tough, certain loan portfolios — in particular commercial real estate — at some banks seem to have gotten off lightly. Meanwhile, the tests' numbers for underlying earnings — which are needed to offset soaring credit losses — could turn out to be optimistic in some cases.

It is hard to quibble with most of the government's worst-case loss rates, which are calculated for this year and next. For example, an 8.8% loss rate for first-lien mortgages seems suitably tough, even when taking into account the aggressive underwriting during the housing bubble. The government's 13.8% worst-case loss-rate for second-lien mortgages seems fair. But it is a stretch to think Wells Fargo, with its large home-equity book focused on stressed housing markets, will have a lower-than-sector loss rate of 13.2%.

[Timothy Geithner]

The government may have been too optimistic in positing an 8.5% commercial-real-estate loss rate. This sector is just starting to fall apart, and defaults may move sharply higher as borrowers struggle to refinance loans. BB&T's commercial-real-estate worst case is higher at 12.6%, but its portfolio may arguably show higher losses.

The government's earnings projections also need to be taken with a pinch of salt. It is optimistic to assume banks can repeat their first-quarter revenue generation, for instance. Given the Fed has unleashed a tidal wave of liquidity into the system, interest rates are going to be extremely volatile for several quarters, making bank revenue very hard to predict.

Another reason to be skeptical is few banks have to substantially increase overall levels of Tier 1 capital, which includes common and preferred shares, by raising new money. The government is effectively saying most large banks were solidly capitalized even when investors fled earlier this year.

Instead of immediately raising overall capital levels, some banks are just shifting the mix toward common equity — the highest-quality capital. Lenders that need to raise fresh money include GMAC, General Motors' lending arm. Also, Wells Fargo's offering of common stock, announced Thursday, suggests its overall capital will increase.

Finally, the government has effectively said it wants banks to have Tier 1 common stock equivalent to 4% of risk-weighted assets. First, investors have to decide whether they have confidence in the risk weightings.

Second, Tier-1 measures of capital leave out certain unrealized losses on securities that could become real later — something captured by tangible-common-equity ratios.

Then they must decide whether 4% — which still translates into 25-to-1 leverage — is safe for the unpredictable environment we are in.

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