Big Banks Face 'Stress Tests' On Stability

The Obama administration hopes to restore confidence in the nation's ailing financial sector by subjecting 19 of the largest banks to "stress tests" that will gauge whether each institution has adequate capital to survive a severe downturn.

Banks that need new funds will be given six months to obtain it from the private sector or, failing that, from the federal government's $700 billion bank rescue program, the Treasury Department said Wednesday.

Treasury officials said the new support will be provided through the government's purchase of preferred shares of the bank stock that are convertible into common shares at a 10 percent discount to their price before Feb. 9.

The preferred shares will carry a 9 percent dividend and be convertible at the bank's option, but subject to regulatory approval.

The option to convert the preferred shares into common shares is a change in the rescue program designed to give the government greater flexibility in managing its assistance.

Common shares absorb losses before preferred shares do, which means that under a stock-conversion plan taxpayers would be on the hook if banks keep writing down billions of dollars' worth of rotten assets, such as dodgy mortgages, as many analysts expect they will.

However, common stock in banks is incredibly cheap, and taxpayers would reap gains if the banks come back to health and the stock price rises.

The Treasury Department also provided details of how a new stress test will function to ensure banks have enough capital to survive a downturn that would be even more severe than the current recession. The tests will be conducted by bank regulators, including the Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision.

Government officials hope the tests will boost market confidence in the banks by making it clear the institutions either have the capital to weather a major downturn, or will obtain it from private investors or the government.

The new stress tests will use two economic scenarios to gauge banks' health and are expected to be completed by the end of April.

The "baseline" scenario envisions the nation's gross domestic product, which is the value of all goods and services produced within the United States and the broadest barometer of the country's economic health, falling 2 percent this year, unemployment rising to 8.4 percent and home prices dropping 14 percent.

The "adverse" scenario assumes GDP will drop 3.3 percent, unemployment rising to 8.9 percent and home prices falling 22 percent this year.