How the Stress Tests Stopped the Market Bleeding

Wall Street Journal

Banks, Investors Got a Breather; No Street Bashing

y DAMIAN PALETTA and MARSHALL ECKBLAD

WASHINGTON -- When the Obama administration announced it was conducting stress tests on the country's largest banks in February, Treasury Secretary Timothy Geithner, the stock market and the banking sector all looked to be headed in the same direction -- down.

The stress tests were met with cynicism. Wells Fargo & Co. Chairman Richard Kovacevich called the tests "asinine" and other executives said banks had more to lose from the tests than gain. Even regulators bickered about whether making the test results public was a good idea. Two weeks after the tests were announced, the Dow Jones Industrial Average hit an 11-year low.

Less than three months later, all three are experiencing a rebound of sorts, underscoring the increasingly widespread view that the tests might mark a turning point in the financial crisis.

Mr. Geithner successfully beat back criticism that the examinations were a political ploy, leaving much of the number-crunching to the Federal Reserve. The stock market regained its footing as consumer confidence crept back. And several major banks reported unexpectedly strong earnings for the first quarter, boosting confidence about their long-term health.

"In February, some financial stocks were trading like insolvency was a foregone conclusion," said Jeff Harte, senior banking analyst at Sandler O'Neill + Partners. "The market now realizes these banks are going to survive."

The Dow Jones Industrial Average fell 1.2% Thursday to 8409.85. But on the floor of the New York Stock Exchange, participants said declines had little to do with any anxiety about stress tests.

"There is reassurance in clarity," Mr. Geithner told reporters Thursday.

To be sure, short sellers -- investors who benefit from a stock's decline -- have increased their share interest in the 18 publicly traded stress-tested financial institutions since late April, according to DataExplorers, a New York and London research firm.

And government officials are bracing for more pain in the banking sector, especially outside the top ranks that were subjected to the tests. There will likely be consolidation among weaker banks and some large banks could be broken into different pieces. There already have been 32 bank failures this year and dozens more are expected to collapse through 2010.

At the outset, the unprecedented tests were compared with President Franklin Roosevelt's "bank holidays," leading many to wonder if the Obama administration would close down weak banks, which is what happened in 1933.

Investors fretted for weeks that the Treasury wanted to nationalize parts of the banking system, despite repeated efforts by Mr. Geithner and others to dispel that idea.

In retrospect, the tests were akin to hitting the pause button. The period allowed Mr. Geithner to buy time for the government's evolving approach to the banking crisis, which had previously been ad hoc and heavily criticized.

In early April, only a few weeks after Citigroup Inc.'s stock closed at $1.02 a share, President Barack Obama said he was starting to see "glimmers of hope" in the economy. Fed Chairman Ben Bernanke's assessment of the outlook also has improved over the past several weeks.

The upbeat statements lifted the stock market, setting the stage for a warmer reception for the stress-test results, especially as it became clearer that even the weakest banks mightn't need lots of new government cash.

"Obama stopped bashing Wall Street. They are learning that it's better to have the market at 8000 than at 6000," said Paul Miller, a banking analyst at FBR Capital Markets, in reference to the level of the Dow industrials.

Senior government officials said the stress tests were as much about bringing confidence back into the banking system as they were about the banks themselves. They also felt that by preparing banks for a "worst-case scenario" with an abundance of capital, they could actually avoid such a scenario.

"The whole point from a public policy perspective is to make sure the banks have enough capital to be able to withstand a stressed environment comfortably," Federal Reserve Bank of New York President William Dudley said. "If banks have enough capital to withstand a stressed environment comfortably, that makes a stressed environment less likely."

Part of the boomlet in bank stocks may well be due to a growing sense among investors and portfolio managers that bank stocks hit bottom in March.

Because many stock pickers rushed to sell financial shares, "many long-only mutual funds have very, very little exposure to the sector," said Jeff Davis, director of research at Howe Barnes Hoefer & Arnett Inc. "We've seen them scrambling to buy." Mutual funds typically disclose their holdings once a month or once a quarter.

A number of analysts pointed out that shares in the 19 stress-tested banks now carry more upside potential than downside risk, if only because the government said in March it would allow none of the 19 firms to fail.

With that assurance in hand, said Brad Hintz, an analyst at Sanford C. Bernstein, the only risk facing bank-stock investors "is dilution risk" -- the worry that a firm will need to raise new common equity, which hurts existing shareholders.

Investors "love to have a one-sided bet, and that's the bet on the financial institutions," Mr. Hintz said.

—Annelena Lobb contributed to this article.

Write to Damian Paletta at damian.paletta@wsj.com and Marshall Eckblad at marshall.eckblad@dowjones.com