It's Just A Little Quiz, Banks

Attention markets: The government has a plan to steel your spines, to help you gain confidence in banks -- specifically -- a "buffer of confidence" for the largest financial institutions. Here is how a senior Treasury official, briefing reporters this afternoon, described the premise behind the administration's new Capital Assistance Program for banks.

"Our hope is that over time, by creating some certainty around a source of common equity for these banks, over time, that that will be confidence creating, because [everyone] will know that that bank has access to high quality common equity over time."

The 19 largest banks with capitalizations of more than $100 billion will be given stress tests, or, in the Treasury vernacular, a "forward looking capital assessment." These tests, government officials said today, will merge current economic data with assessment of the banks' assets and liabilities. There are two scenarios: a "baseline" scenario that comes from the average of the February projections from professional forecasters and a worst-case scenario forecast -- i.e., the bottom falls out. The baseline scenario assumes a 2% economic growth rate in 2010 with unemployment topping out at 8.8%. The real bad scenario assumes that there will be some growth in 2010 but that unemployment will be significantly higher - up to 10.3%.

Based on the results of the tests, the banks, the Treasury, the Fed and the FDIC will determine how much tier one capital each institution needs to remain nice and solvent. There doesn't seem to be a single metric - Citigroup, for example, claims to have a tier one capital ratio - a measure of capital against a bank's risk-[weighted assets -- of nearly 12 percent -- well above the standard -- and yet the government is clearly worried about the bank's solvency.

The banks will then be given six months to come up with these "buffers" from private sources of capital. If they can't, then the Treasury will purchase convertible preferred shares from the banks, although, owing to fears about the degree of government control, the Treasury describes the authority in a passive voice: "B[ank holding companies] that have undergone this forward-looking capital test will have access to Treasury capital in the form of mandatory convertible preferred shares."

On a conference call with government officials I asked "[whether] these tests determine whether the bank needs capital buffer, is participation in the CAP program mandatory or voluntary if the banks can't come up with private sources in six months?" (A Fed official disputed the notion that the "test" is a "test," calling it a supervisory assessment ... although the Treasury Department calls it a test. Maybe it's a quiz.)

Anyway -- the answer is -- yes. "We want to make sure that, at the conclusion of the assessment ... there is a clear certainty" that banks will get money from either private sources or the government. It will be forced to take the money, and, "our hope is that some of those institutions will be able to meet that need in the private market," a Treasury official said.

Importantly, to preserve confidence in the banks, the government won't release the tests/assessments to the public. The banks will be required to release, in monthly installments, how much they're lending and who's getting the money.

The CAP program itself consists of preferred securities, fully convertible into common stock that can be purchased at a ten percent discount relative to the price as of February 9. The idea is that, as the bank raises more private capital, it can sell the instruments back to the government at a profit. A Treasury official said that there is no artificial limit on the amount of capital that a bank can obtain from the government. Officials wouldn't provide estimates as to the total cost of CAP.