What Are the Banks Haggling Over?

Highlights include Bank of America Corp. (BAC - Analyst Report), Citigroup, Inc. (C - Analyst Report), Wells Fargo & Co. (WFC - Analyst Report), SunTrust Banks, Inc. (STI - Snapshot Report), Regions Financial Services, Inc. (RF - Analyst Report), American International Group, Inc. (AIG - Snapshot Report) and Morgan Stanley (MS - Snapshot Report).

The much-awaited results on the stress tests have been delayed till Thursday and the market currently is rife with rumors, speculations, "leaked reports" and denials-on which banks will "fail" the stress test.

Among the banks that are being reported to be in need of more capital are Bank of America (BAC - Analyst Report), Citigroup (C - Analyst Report), Wells Fargo (WFC - Analyst Report), SunTrust (STI - Snapshot Report) and Regions Financial (RF - Analyst Report). The banks are currently negotiating with the regulators over the amount of capital Treasury is going to require them to raise -- in other words, they are trying to convince the regulators that they are healthier and better-capitalized than they actually are.

While it is unclear how flexible the regulators will be about adjusting the assessments, it is being reported that some banks are trying to convince them to use their first-quarter 2009 results to project their revenues for the next two years. This has a potential of further undermining the credibility of the stress tests, which are already being widely criticized for not being "stressful enough."

Many banks had strong first-quarter performances results, which are not sustainable, as the banks themselves have admitted. Near-zero funding costs and a surge in refinancing due to record-low mortgage rates and better revenues from fixed income trading (resulting from the high volatility) helped the results. While we do not expect the rates to go up in the near term, they will not remain at current levels over the next two years. Once the Fed sees signs of inflation in the economy, it will have to raise the rates and also stop/slow down its purchases of mortgage-backed securities.  Major banks also benefited from large AIG (AIG - Snapshot Report) payouts.

And some banks benefited from strange accounting rules. Citi recorded a profit of $2.5 billion, and Bank of America recorded a profit of $2.2 billion, resulting from widening of their credit spreads (worsening of creditworthiness), and on the other hand Morgan Stanley (MS - Snapshot Report) recorded a loss of $1.5 billion due to the tightening of its credit spreads. So if the credit spreads tighten for Citi and Bank of America in near future (are the stress tests not supposed to increase the confidence in the banking system?), will they not be required to record huge losses?