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Pass or fail, U.S. banks bow again to Washington

A couple of weeks ago, not long before disgruntled shareholders stripped him of his chairman's title, Bank of America chief executive officer Ken Lewis insisted he was done drinking from the government trough.

But U.S. President Barack Obama and his team of number crunchers at the Treasury Department apparently beg to differ. Thursday, after markets close, the U.S. government will publish the results of a much-hyped stress test designed to measure the health of the country's 19 largest financial institutions.

About 10 of these companies will be forced to buttress their capital base, and none faces such a gaping deficiency as Bank of America. Published reports suggest the bank will have to raise an additional $34-billion (U.S.) in capital, or roughly half its market value, despite its insistence it has an adequate cushion to withstand poor economic conditions.

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The subtext here is clear: The stress test increasingly looks like a stealthy nationalization of some of the largest U.S. banks, with Washington - not bank CEOs - calling the shots.

U.S. officials have always been leery of using the "nationalization" term, given its socialist connotations. Yet there is little doubt that with these stress tests, the Obama administration is tightening its grip on the financial sector.

Take Bank of America. Although it can sell some assets or attempt to raise money in the markets, this likely won't get it near the $34-billion target. Instead, it may have to convert a chunk of the government's preferred stock investment into common equity, turning Washington into a powerful shareholder with considerable clout.

During a press conference Wednesday, White House spokesman Robert Gibbs acknowledged the government may become more interventionist following the release of the stress tests, and push for management changes at some of the weaker banks - much as the White House did with troubled insurer American International Group, the mortgage giants Fannie Mae and Freddie Mac, and embattled auto maker General Motors.

In fact, the government has already brought considerable pressure to bear on companies it doesn't explicitly control. In private testimony to New York's Attorney-General this spring, which has been widely reported, Mr. Lewis asserted the government forced him to buy Merrill Lynch last year after he attempted to back out, and warned him he could be fired if he didn't consummate the deal.

The White House's Mr. Gibbs noted that the government has "weighed in" on managerial matters in both the financial and automotive sectors, and said that once the stress test results are public, Mr. Obama's team will take steps to "ensure that going forward they felt that the management was in place to remedy the situation and ensure long-term viability without continued government assistance."

Many observers have interpreted these kinds of comments to mean the jobs of Mr. Lewis, who is already under pressure for his handling of the Merrill purchase, and Vikram Pandit, the head of Citigroup Inc., are in jeopardy.

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Mr. Lewis clearly didn't see the government's demands coming.

He insisted in a recent interview with CNBC that his bank's balance sheet was in fine shape, and that Bank of America, which had already received $45-billion in aid from Washington, was strong enough to weather poor economic conditions on its own.

"We're not expecting to need more capital," he said. "The issue, of course … is will some [banks]be required to convert some of their preferred [stock]to common? We don't think we have an issue there."

When Bank of America was told that it would have to raise a huge pile of cash, the bank fought back, and other investors, including Warren Buffett, have suggested that at least some of the banks are stronger than the tests imply. The Obama administration has been unmoved.

The result is that Treasury has deemed that Citigroup, which has required significant government help (and which now counts Washington as its biggest shareholder), needs about $5-billion, while Wells Fargo & Co., a Buffett favourite and a bank many consider to be in decent shape, requires $15-billion. GMAC LLC, the struggling finance arm of General Motors, will have to come up with $11.5-billion, according to numbers that leaked out yesterday.

Goldman Sachs Group Inc., Morgan Stanley, MetLife Inc., JPMorgan Chase & Co., Bank of New York Mellon Corp. and American Express Co. are expected to pass the stress test without additional capital.

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J. Steele Alphin, Bank of America's chief administrative officer, said the company would have plenty of options to raise the capital on its own before it would have to convert any of the taxpayer money into common stock, although several analysts remain skeptical.

It's a poor time for banks to tap the markets right now, and it's far from clear that auctioning off Bank of America's stake in China Construction Bank or wealth manager Blackrock could help reach the government's target number.

Oddly, given the size of Bank of America's capital needs, the company's stock went on a tear yesterday, gaining 17 per cent to $12.69 in New York trading. There was some thought that the number was smaller than some analysts and investors were expecting; others postulated that reports on the government's findings had at the very least given the market some certainty.

The credit default swap market, which tracks how expensive it is to insure against a company's potential default, showed that that best performers Wednesday were the banks that do need more capital. Credit default spreads on Citigroup and Bank of America contracted much more than spreads on JPMorgan, meaning investors were less fearful of a possible collapse.

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