Smith Faculty Opinion Article

By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

May 7, 2009

Stress Tests: Investors Should Steer Clear of Banks Found Needing New Capital

Whether or not the banks needed them, the Federal Reserve has completed the stressed tests. It has acted on pleadings from bank executives and will announce which major banks need to raise more capital late Thursday afternoon.

The stress tests imposed a severe economic scenario to test the capital adequacy of the nation’s largest banks, and they require that adequate capital only be in paid-in common stock.

To avert a hypothetical calamity and theoretical big bank failures, the Obama Administration will require banks found lacking in this fabricated financial tsunami to sell more common shares. If they can’t find enough buyers, TARP investments will be converted to common shares and additional government funds will be provided as may be necessary.

S&P has indicated it will downgrade about half the banks directed to raise new capital. Apart from the dilution, this downgrades immediately stocks and bonds worth less.

Investors would be foolish to purchase any common stock or bonds in a bank requiring additional capital if any uncertainty emerges about the bank’s ability to raise all the new capital from private sources. No one should want to own shares in a bank with even the prospect of partial government ownership.

After seeing the Obama Administration’s helping hand at Bank of America, Citigroup, Chrysler and GM, an investor would have to be nuts to buy shares in a bank that requires more capital according to the government’s criteria, because private investors will likely end up with Washington as a partial and dominant shareholder too.

At Chrysler and GM, President Obama is canceling the legitimate claims of private creditors, ignoring the clear requirements of bankruptcy law, and subverting private property rights without due process. Only a fool would buy common stock or bonds in a bank with even the prospects of partial government ownership.

After President Obama arbitrary treatment of private creditors at Chrysler and GM, I would just as soon take a beating from a prize fighter than buy stocks or bonds in a bank ordered to raise capital by the Obama stress tests.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.