Stress test methodology could send banking industry into tailspin

Tension surrounding the announcements highlights the high-stakes nature of the stress tests, a centerpiece of the Obama administration's plan for bolstering the financial system. For months, officials have put off questions about the banking system by saying they're awaiting the test results.
WASHINGTON - Regulators trying to stabilize the financial system could unwittingly roil it when they explain their methods today for stress-testing the largest banks.
Officials will privately begin telling the largest 19 financial institutions how they performed. But investors will be scrutinizing the test methodology for clues about which banks are in trouble.
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The results won't be publicly released until May 4.
The slow-motion rollout is intended to blunt market reaction to the news of which banks are healthy, which ones could fail if the recession worsens and which need more money to survive.
News reports, including a confidential outline of the tests first reported by The Associated Press this week, have led analysts to start handicapping which banks could fail. The speculation will intensify with today's release of the test methodology.
"I'm worried about the overreaction - people selling every bank short and pulling out all their deposits and hiding their money in the mattress," said Scott Talbott, a lobbyist with the Financial Services Roundtable, which represents the biggest financial firms.
Regulators are striving to release enough information about the stress tests to inspire confidence. But they don't want to give analysts so much detail that they can run their own tests on the banks before the official release of results.
The stress tests subject banks' balance sheets to two scenarios. One reflects current forecasts for the recession. The other assumes the recession will worsen, according to the document, produced by the Federal Reserve.
Officials also are examining the quality of banks' loans, according to an industry official and a regulatory official who spoke on condition of anonymity because they weren't authorized to discuss the tests publicly.
The goal is to see if banks have enough money reserved to withstand these losses. If they don't, regulators will force banks to boost their capital, with private or government money, and will take other steps to strengthen their balance sheets.
Some experts fear the hypotheticals aren't tough enough.
"The question is, will the market accept the stress test as a realistic case?" said Paul Miller, an analyst with Friedman, Billings, Ramsey & Co.
Recent economic indicators show the economy is approaching the more severe of the government's two scenarios, Miller said.
And there also are risks in outlining a test that will be tough on some banks, said Lawrence Brown, an accounting professor at Georgia State University.
"The more information we get as to what those outcomes are likely to be ... the more investors will drag down the banks that aren't perceived to be healthy," said Brown, who studies market behavior.

When senior White House adviser David Axelrod was asked in an interview last week with The Associated Press about a separate plan to buy up banks' assets, he replied, "Let's see what happens once the stress tests are done and the capital needs of banks are determined."
The delays have led investors to fret: If the tests show every bank to be strong, they will look like a whitewash and won't be taken seriously.
Yet once investors can distinguish stronger from weaker banks, they could start selling off weaker banks that remain stable but might falter if the recession got much worse.