Can Your Bank Pass the Stress Test?

For months, customers and investors have wondered if their banks will survive. The government may soon give its opinion. But don't be surprised if you find the answer inconclusive.

In early February, Treasury Secretary Timothy Geithner, as part of his bank fix, said he will "stress-test" the nation's largest financial firms to find out which ones are fit and which ones are flatlining, and then apply the appropriate therapy — which we assume means anything from injecting capital to pulling the plug. By using a medical term, Geithner gave the impression that he had some fiscal electrocardiograph that could be strapped to banks to chart the strength of their accounts. But when it comes to a bank checkup, the actual test is far less scientific. (Read "Geithner's Challenge: Selling a Plan Without the Details.")

In theory, a financial stress test looks at a firm's loans, assesses which will go bad and then concludes whether the bank will have money left when those accounts go unpaid. Pretty clear.

But in reality, to run the test, you have to guess not just which borrowers will stop paying but also when. Some losses will be covered by profits elsewhere. So the firm's bottom line must be estimated. The variables leave plenty of room for the government to make some banks look better or worse, depending on the assumptions it makes. Not so cut and dried. (Read "25 People to Blame for the Financial Crisis.")

Geithner hasn't detailed his test, other than that it won't be complete for another month. Worse, officials at the Treasury say the tests probably won't be made public. That will sort out the uncertainty that has driven the stock market down, won't it?

So instead of waiting around for the government's finger-in-the-air results, Time decided to poke and prod the banks on its own.

To do so, we relied on the loan-loss estimates of New York University professor Nouriel Roubini, a.k.a. Dr. Doom, who has been sagelike in his predictions about the credit crisis so far. We factored in the banks' results this year, as projected by Wall Street analysts. Besides the hit that banks will take for soured loans, the firms also have losses in their investment accounts. But since markets go up as well as down, we stuck to the actual cost of their lending foibles rather than guess where the market for debt is headed next.

The exception is Citigroup. Since the bank struck a deal with the government to shield $301 billion in losses, we had to account for some investment missteps to value the arrangement. Bank of America has a similar deal, but since the details aren't public, we didn't factor it in. (See pictures of the top 10 scared traders.)

Any stress test is also influenced by the measure you use. We chose the leverage ratio. To calculate it, divide a bank's equity by its assets, much of which are loans. The lower this ratio goes, the shakier a bank becomes. For example, a 10% leverage ratio means the bank has lent out $10 for every $1 in equity it has. A 5% reading translates to $20 out for every $1 in hand. Regulators like to see a reading of at least 5%. Anything less than that and a bank could become toast. Here's what we found:

Citigroup
Loan losses: Even after making a government deal, the bank is still on the hook for the first $40 billion in loan losses in the pool it has insured. Citi also has $277 billion in other, nonhousing consumer loans, such as credit cards and student debt. Roubini estimates that about 17% of consumer loans will go unpaid nationwide. That translates into a $47 billion river of red ink. Add in everything else (commercial real estate, corporate loans), and Citigroup will have to swallow $106 billion in loan losses by the end of 2010.

Capital cushion: Thanks to the Troubled Asset Relief Program (TARP), Citigroup now has $151 billion in equity, up from $113 billion a year ago. Alas, it will have a $76 billion hit from bad loans. Along with a projected bottom-line loss of $3.5 billion, that drops the bank's capital to $70.5 billion.

Prognosis: On the way to the ICU. Citigroup has a projected leverage ratio of just 3.8% — far lower than what it would need to be considered well capitalized. How much would the U.S. have to give the bank to nurse it back to good health? About $22 billion.

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