(The following statement was released by the rating agency)
(Editor's note: This is the introduction to a six-article special report, all of which can be found on RatingsDirect.)
May 13 - Despite the cautious optimism creeping into the financial markets, in light of what some believe are better-than-expected results from the government stress testing of 19 large banks, Standard & Poor's Ratings Services believes that banks are far from a recovery, and the banking crisis has merely entered a new phase.
Still, it's difficult to predict just how long this phase will last. But as Tanya Azarchs, a managing director at Standard & Poor's said at the recent Standard & Poor's Financial Institutions Hot Topics Seminar, although our analytical time horizon for losses extends only through 2010, "there's nothing to say that this banking crisis can't go on for another three or four years." One thing is clear, however: banks will have a tough time surviving unless they have "more capital than even Basel envisioned," she explained. Fortunately, many banks--especially financial institutions that were the initial recipients of funds from the U.S. Treasury's Troubled Asset Relief Program (TARP) and that we therefore believe regulators consider highly systemically important--benefit from the government's widespread funding and capital support programs.
Although we view this extraordinary support as temporary, and limits may exist in the future as TARP funds dwindle, "there is no indication in our view that the support is waning," said Scott Sprinzen, a managing director at Standard & Poor's. Among the several programs Mr. Sprinzen highlighted, the Federal Depository Insurance Corp.'s Temporary Liquidity Guarantee Program has been among the greatest benefits for banks in terms of keeping them afloat with guarantees on deposits and debt. But it has also created "a mountain of refinancing that they will have to contend with at some point," he said. In addition, both the Troubled Asset-Backed Securities Loan Facility and Public-Private Investment Partnership (PPIP) are promising, although there appears to be more optimism with the ability of the former to reignite the securitization markets. With PPIP, attempting to remove distressed assets from banks' books, he says "may trigger more losses, potentially creating more of a hurdle."
The Federal Reserve Board's stress testing, the results of which were announced May 7, found that that 10 of the 19 largest banks need a total of $75 billion in capital to maintain at least 4% of common equity Tier 1 capital if the environment becomes a lot more adverse than experts currently expect. This compares with Standard & Poor's assessment of an $18 billion need for these 19 banks on the basis solely of credit stress testing. Despite the significantly higher capital requirements determined by the Fed's stress tests as compared to our stress tests, we do not see this as an unmanageable amount, and most management teams of the identified banks promptly issued statements about how they would raise the capital (see "The U.S. Federal Reserve's Stress Test Results: The Beginning Of The End Or The End Of The Beginning For U.S. Banks?" published on RatingsDirect on May 12, 2009).
Standard & Poor's completed its own base-case stress testing of banks' loan portfolios, focusing on credit and earnings risks and their impact on capital adequacy (see "What Stress Tests Reveal About U.S. Banks' Capital Needs," published on RatingsDirect on May 1, 2009). Subsequently, on May 4, we placed ratings on 23 financial institutions on CreditWatch with negative implications. The results, and the rating actions, are wholly independent of the stress testing regulators conducted and indicate widespread, though not necessarily severe, capital needs that could result in downgrades of several notches.
Rodrigo Quintanilla, a managing director at Standard & Poor's, said that the Financial Institutions group has conducted stress testing for years as just one of many procedures it follows in its normal course of analyzing banks' portfolios. "It's a tool that crystallizes our expectations," he said. On Friday, May 8, we affirmed our 'A/A-1' counterparty credit ratings on Bank of America Corp. and on Citigroup Inc., and removed those ratings from CreditWatch. For both cases, the affirmations reflect our renewed confidence in the strength of government support that would be forthcoming if needed based on our recent discussions with bank regulators. These two institutions were the only ones in which explicit government support has been factored. In fact, the standalone assessment of Citigroup is four notches below its issuer credit rating (ICR) of 'A+/Stable/A-1', and Bank of America's is three. We also expect capital-boosting measures in the face of the government stress tests to cushion against even higher, unanticipated losses, and credit losses under our stress tests to be manageable.
The Fed's stress test has been just another step toward the eventual recovery of the global financial industry, but the industry still faces challenges presented by these developing trends:
-- Industry risk is generally creeping higher rather than stabilizing;
-- Losses during this downturn will likely be greater than the industry thought when it began;
-- Franchise stability and market confidence are increasingly critical components of credit;
-- There's a greater focus on capital adequacy;
-- Government support is now explicit in our ratings for highly systemically important U.S. banks;
-- Hybrid securities appear to be riskier than we thought;
-- The industry structure is changing; -- Volatility appears to be here to stay;
-- The originate-to-distribute model is being rethought; and
-- Regulation is generally increasing.
In December 2008, we began incorporating government support into our credit ratings on highly systemically important U.S. banks (see "Twelve Major U.S. And European Financial Institutions Have Ratings Lowered, Outlooks Revised," published on RatingsDirect on Dec. 19, 2008). "We continually examine and refine our analytical focus," Mr. Quintanilla said, explaining the decision. In doing so, Standard & Poor's recently refined some of its analytical tools, criteria, and assumptions. Stress testing and a newly introduced risk-adjusted capital framework are two such components. "We continue to focus on fundamentals and our goal is to provide credit opinions that are independent, objective, and transparent assessments of creditworthiness," he said.
Primary Credit Analyst: Rodrigo Quintanilla, New York (1) 212-438-3090; firstname.lastname@example.org