Time to Cram? Government Sets Bank 'Stress Tests'

The tests will help determine whether the banks could survive more losses.

Feb. 25, 2009 — -- If today's ravaged economy falls into even more dire straits, will your bank survive?

That's what multiple federal agencies will try to determine starting today as the government kicks off the Capital Assistance Program, a new effort by the Obama administration that is designed to ensure major U.S. banks play a role in the recovery of the American economy.

"We're going to do an honest evaluation. We're going to do a tough evaluation [to] try to figure out how much hole there is, if there is a hole," Federal Reserve Chairman Ben Bernanke said Tuesday in testimony before the Senate Banking Committee.

Under the program, the country's largest banks will undergo "stress tests" performed by the government. The tests will measure if banks can weather what-if economic conditions that could emerge over the next two years, which analysts say could include much higher unemployment and further drops in home values.

If they can't, the banks stand to receive more federal aid on top of the hundreds of billions already provided by the Troubled Assets Relief Program under the Bush administration. The program, according to a government statement released this week, calls for the banks to seek private investment before turning to the government for a "temporary capital buffer."

Tuesday Bernanke rejected concerns that the government's assistance to the banks would ultimately result in nationalization -- a fear that contributed to turmoil in the stock market earlier this week.

"It's not nationalization, because the banks would not be wholly owned or probably not even majority owned by the government. The government will be a shareholder, along with private shareholders," he said.

Some say that government regulators tasked with keeping tabs on the banks should already know whether they would survive an even deeper downturn. But the stress tests could help reassure a public unnerved by the distribution of the government's original TARP funds.

"Taxpayers need accountability, and using a stress test is one method of the government showing, 'We've looked at these banks -- this is a prudent investment for the taxpayers to make,'" said Morningstar banking analyst Jamie Peters.

In his address before a joint session of Congress Tuesday night, President Obama sought to distinguish early TARP spending from his adminstration's plans.

"I understand that when the last administration asked this Congress to provide assistance for struggling banks, Democrats and Republicans alike were infuriated by the mismanagement and results that followed. So were the American taxpayers. So was I," he said. " So I know how unpopular it is to be seen as helping banks right now, especially when everyone is suffering in part from their bad decisions."

Obama said he would hold the banks "fully accountable for the assistance they receive."

"And this time," he said, "they will have to clearly demonstrate how taxpayer dollars result in more lending for the American taxpayer."

Financial Firms Already Stressed

Not everyone thinks the tests will have a reassuring effect, including Paul O'Neill, who served as treasury secretary under President Bush but later emerged as a fierce critic of Bush's policies. In an e-mail to ABCNews.com, he criticized the current government, questioning how much influence federal officials will actually have.

"Is the market going to accept a judgment from people who have no credibility?" he asked. "I don't think so."

Bernanke said that the country's largest 19 banks with assets above $100 billion would be subject to the stress tests. Banks meeting the $100 billion threshold include struggling Citigroup, which made headlines this week after news surfaced that the bank may be in talks to change the way the government has invested in the bank, raising its stake in Citi to as much as 40 percent.

The change would not require more government money but would entail the conversion of much of the government's $45 billion investment -- which is now in preferred shares -- into common stock. Such a move, Morningstar's Peters said, would expose the government to Citi's stock market fluctuations.

"For the taxpayer, they are going to be taking some downside risk," she said, adding that the taxpayer could also stand to benefit if Citi's stocks recover.

Citi's name has been floated as one of the banks that will likely require more government aid after the stress tests. A Citi spokesman declined to comment on the stress tests.

The bank itself released a statement Monday touting its "very strong" capital base and its progress in "reducing the assets on our balance sheet, reducing expenses and streamlining our business for future profitable growth."

Ailing insurance giant American International Group, which has received $150 billion in government assistance, is also in talks to convert the government's preferred shares to common stock, Bloomberg reported.

Asked about the report, AIG spokeswoman Christina Pretto told ABC News that the firm continues "to work with the U.S. government to evaluate potential new alternatives for addressing AIG's financial challenges."

How Healthy Are the Banks?

Despite the grim financial news, Mark Tenhundfeld, an American Bankers Association senior vice president, said he believes most banks will come through the tests "with flying colors."

"In point of fact, banks are healthier than a lot of people are giving them credit for them right now," he said.

The public, however, may not learn exactly how healthy the banks are: While the government is expected to disclose which banks will ultimately receive more government capital, it's unclear whether it will disclose how the banks fared on the stress tests.

"I think they would want to avoid any nervousness in the market," said Neena Mishra, a banking analyst with Zacks Investment Research. Federal officials, Mishra said, may worry that providing more information could result in a run on the banks.

Tenhundfeld agreed.

"Any time confidential information is disclosed, there's always a danger that it will be misunderstood and that people will act on it in ways that are irrational," he said. "Regulators are trying to preserve confidence in the banks and essentially communicate the message that the public doesn't need to be concerned about the viability of these institutions."

O'Neill, however, has argued for publicizing more, not less, information about the banks.

"If I were in charge, I would require each financial institution to classify their assets, by amount, into rating classes, beginning with AAA, and then down [through] the investment grade ratings. … All of this would be posted on the Internet," he said in an e-mail.

"The argument against doing this is that we can't handle the truth," he said. "However gruesome the truth may be, I believe the truth would give us a base to build on."

ABC News' Eileen Murphy and Charles Herman contributed to this report.