Fed Orders Big Banks to Raise ‘What-if’ Capital To Bolster Reserves

If the economy were to take a sudden dive, the nation’s top banks could suffer commercial real estate losses amounting to $53 billion, or 8.5% of their total losses. Such massive losses could occur if the U.S. unemployment rate were to reach 10.3% in 2010 and home values were to plummet 22% this year and 7% the following year in a grim scenario posed by government regulators to test the banks’ health. Total losses among the 19 largest banks would rise to $600 billion.

The Federal Reserve has ordered 10 of the big banks to take steps to remedy their capital positions, according to a strict timetable. They have one month to develop a plan to prevent shortfalls, and six months to raise the additional $74.6 billion capital to bolster their reserves. The stress tests conducted by regulators revealed that the banks could be caught short of adequate funds to protect the reserves if the economy worsens. Consequently, many banks have been directed to pump more capital into their systems now to weather potential shocks.

Projected commercial real estate losses were far smaller than residential and consumer losses, which accounted for 70% of the total estimated losses in the scenario. The lion’s share of commercial real estate losses came from Bank of America, $9.4 billion of the $53 billion total, and Wells Fargo, $8.4 billion. That figure represented 9.1% of Bank of America’s projected losses, and 5.9% in the case of Wells Fargo.

However, even those huge losses did not sting the banking giants as much as Morgan Stanley’s estimated $600 million in commercial real estate losses, which represented a whopping 45.2% of its total losses in the government’s projections. GMAC’s $600 million in commercial real estate losses under the scenario amounted to 33.3% of its total losses from all sources including home mortgage and credit card debt defaults. The loss percentages for Morgan Stanley and GMAC revealed a high concentration of the institutions’ loans in commercial real estate.

Gauging the health of the nation’s banks is critically important for the commercial real estate industry, says Bob Bach, chief economist for brokerage and financial services company Grubb & Ellis.

The value of properties depends to a great extent on the amount and terms of the debt you can put on a property, Bach says, and the industry depends on leverage to keep returns healthy. “It’s crucial for our industry that the credit markets return to health. I think the results of the test will be viewed as a proxy for the health of the credit markets in general, for all banks, and all lenders.”

The tests highlighted the problems some banks have developed over the last few years as higher concentrations of their loan portfolios shifted toward commercial real estate.

“There is a lot of concern among the regulators about problems in commercial real estate. They’re coming on stream later than the housing problems,” says Alexandria, Va.-based financial consultant Bert Ely.

The government created ‘What if?” scenarios to gauge potential losses under a more extreme scenario than it expects to occur through 2010, says Treasury Department spokesman Andrew Williams. “We’re making clear what kind of buffer they need. We’ve also said that over the next month banks will have to get a plan to make sure that if there is a shortfall in that buffer, how they’re going to get that [capital].”

Regulators want the companies to raise private capital, he says, although public funds could be available if needed. “They have one month to put their plan together and give it to regulators for approval. Within six months of [May 7] is the target for them to raise that additional buffer capital, if needed.”

The big projected losses on commercial real estate loans, especially those related to land development, reflect the plunge in real estate values that could occur in a brutal downturn. More than 150 examiners and economists from the Federal Reserve, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp. participated in the stress tests of the 19 powerful banking companies, which collectively hold about two-thirds of the assets of the U.S. banking system. The smallest of the banks studied was KeyCorp, which has $105 billion in assets.

“These examinations were not tests of solvency; we knew already that all these institutions meet regulatory capital standards,” said Federal Reserve Chairman Ben Bernanke in a statement. Rather, the assessment program was intended to help regulators gauge the extent of the additional capital buffer necessary to keep banks strongly capitalized and lending, even if the economy performs worse than expected between now and the end of next year.

Nearly all the banks had enough capital to absorb the higher envisioned losses, but about half the companies were told to bolster their common equity, which the Fed says provides institutions the best protection against loss during periods of stress. Common equity is the first element of a capital structure to absorb losses, buffering the structure and lowering the risk of insolvency, examiners noted. Under pressure, it conserves resources by changing the amount and timing of dividends and other monetary distributions.

Many of the tested banks have already acted to bolster their resources and are well positioned to raise funds from private sources over the next six months, Bernanke noted. However, the Treasury Department stands ready to provide any additional capital that may be necessary to ensure that the banking system can navigate a challenging economic downturn, the chairman added.

Even before the tests, regulators had already been pressing financial institutions to impose new standards that will undoubtedly benefit commercial real estate investors. The Federal Reserve Bank of New York has taken steps to improve the accuracy of trade information regarding credit default swaps and other over-the-counter derivatives. Bernanke says such relatively new financial instruments require still more stringent performance standards, which regulators plan to implement.

Weaknesses in the nation’s financial system revealed over the past two years during the protracted credit crisis and recession made it urgent for the federal government to find ways to shore up the financial system. The ongoing crisis has also pointed out shortcomings in governmental oversight.

Estimates of all needs for 2010 suggest that most bank holding companies will need to build reserves, representing a net drain on resources, the report noted. The banks can raise common equity by selling subsidiaries, converting preferred stock, or issuing common shares, examiners said.

“It is imperative that we apply the lessons of this experience to strengthen our regulatory system, both at the level of its overall architecture and in its daily execution,” the regulators concluded in their report. “As the past two years have brought home to everyone, the development of a more stable and sound financial system should be of the highest priority.”

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