HOSPITAL PASS

Whether or not the banks actually needed them, the Federal Reserve has completed the stress tests. It has acted on pleadings from bank executives and announced which major banks needed to raise more capital. The stress tests imposed a severe economic scenario to test the capital adequacy of the nation?s largest banks, and they require that adequate capital only be in paid-in common stock.

To avert a hypothetical calamity and theoretical big bank failures, the Obama Administration requires that banks found lacking in this fabricated financial tsunami must sell more common shares. If they can?t find enough buyers, TARP investments will be converted to common shares and additional government funds will be provided as may be necessary.

S&P has indicated it will downgrade about half the banks directed to raise new capital. Apart from the dilution, this immediately downgrades stocks and bonds worth less.

Investors would be foolish to purchase any common stock or bonds in a bank requiring additional capital if any uncertainty emerges about the bank?s ability to raise all the new capital from private sources. No one should want to own shares in a bank with even the prospect of partial government ownership.

After seeing the Obama Administration's helping hand at Bank of America, Citigroup, Chrysler and GM, an investor would have to be nuts to buy shares in a bank that requires more capital according to the government?s criteria, because private investors will likely end up with Washington as a partial and dominant shareholder too.

At Chrysler and GM, President Obama is canceling the legitimate claims of private creditors, ignoring the clear requirements of bankruptcy law, and subverting private property rights without due process. Only a fool would buy common stock or bonds in a bank with even the prospects of partial government ownership.

After President Obama's arbitrary treatment of private creditors at Chrysler and GM, I would just as soon take a beating from a prize fighter than buy stocks or bonds in a bank ordered to raise capital by the Obama stress tests.

STAGGER OR STAND?

Since the results, six banks have together sold $19 billion of common stock, going some way to plugging the $75 billion overall capital gap that the tests identified. Further capital-raising is imminent. Bank of America has the biggest shortfall. It plans to sell shares worth $17 billion and has already sold a $7.3 billion stake in China Construction Bank to mainly Chinese and Singaporean investors. Add in a couple more bumper quarters of earnings, the banks say, and the $75 billion gap will close. Only GMAC seems at risk of being nationalized. The former financing arm of General Motors is now partly owned by private-equity firms and is terribly thinly capitalized.

That any bank can sell equity is one big benefit of the stress test. By producing a credible estimate of losses over the next two years ? $600 billion ? officials have restored some confidence in the banks? word. Many observers believe the economic assumptions being used are a bit too optimistic (although the IMF has come up with a similar number for losses). But investors can now buy a bank?s shares and be confident that its books are not being cooked flagrantly and that it is not about to be nationalized. The rally in recent months has helped, as has the commendably clear presentation of the test results.

Although banks typically run down capital in a recession, it is clear that they still do not command enough market confidence to borrow at commercially attractive rates. Immediately after the stress-test results, Bank of America and Morgan Stanley issued bonds without state guarantees. If this was meant to be a show of bravado it fell flat; both paid an interest rate of four to five percentage points more than the government. JPMorgan Chase, which passed the stress test and is judged America?s safest bank by many, issued debt at a spread of about three percentage points, a little less than it paid in April.

In effect, the stress tests asked American banks if they had more capital than losses. A better question is whether they have enough capital to stand on their own without a state guarantee. Any hopes that Europe might do better were dashed when its regulators promised to conduct similar tests, to keep the results secret and to avoid singling out individual lenders. That points to a Japanese-style future for Western banks, in which a thinly capitalized system staggers along, insisting on its rude health, while the state follows holding crutches an inch beneath its armpits. If that is the answer, then the stress tests were asking the wrong question.

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Peter Morici, a former chief economist at the U.S. International Trade Commission, is now a professor at the Robert H. Smith School of Business, University of Maryland, College Park, MD 20742-1815, 703-549-4338, www.smith.umd.edu.

"Stagger Or Stand?" was sourced from the May issue of The Economist.