WASHINGTON — The government laid out its framework for evaluating the nation's 19 largest banks Friday, not providing the specific loss estimates being used in the "stress tests" but suggesting that regulators have aggressively sought detailed information from individual firms.
The report released by the Federal Reserve gives the first peek behind how government officials are determining whether the largest banks need additional capital. Banks have received an estimate from the government on how much capital they will need to raise, and executives and officials are expected to negotiate on a final figure over the next week. The government will then release the results of the "stress tests" May 4, including some company-specific information.
The report says more than 150 federal regulators, examiners and economists have been involved in the tests, which were used to determine how much extra capital each bank needs. The goal, the Fed said, is for these firms to remain "sufficiently capitalized" over the next two years while still being able to lend to consumers.
"Given the heightened uncertainty around the future course of the U.S. economy and potential losses in the banking system, supervisors believe it prudent for large bank holding companies to hold additional capital to provide a buffer against higher losses than generally expected," the report said.
The stress tests required banks to project their credit losses and revenues for 2009 and 2010, including the reserves needed at the end of that period to cover expected losses in 2011. Those losses were projected using two alternative economic scenarios based on standard projections, including a more dire economic scenario that would see unemployment climb to 10.3% in 2010.
The Fed noted that the more adverse scenario was not meant to represent a "worst-case scenario," rather it reflects "conditions that are severe but plausible."
The government also provided banks a standardized set of losses for various categories of loans which were used to project losses. These calculations by the banks were then compared to individual assessments by government regulators, and any discrepancies resulted in further examination and discussions between the firms and their supervisors.
The following is a description of the information collected from banks and how regulators evaluated different loan types and categories:
— First and Second Lien Mortgages: Firms had to provide significantly granular data on their portfolios, including geography, level of documentation, year of origination and loan-to-value ratio. Different loan products were evaluated separately, and firm's models and assumptions were compared to independent assessments and to other banks undergoing the stress tests. Regulators found that credit scores, loan-to-value bands, vintage and product type were "strongly predictive of default."
— Credit Cards: Regulators collected data on payment rates, credit scores, and geographic concentrations. Firm-specific portfolio risk profiles were then created and compared among the banks being tested, allowing regulators to judge whether banks were being reasonable with their assumptions. Some adjustments to loss rates were made, the Fed said, but generally banks and regulators agreed on estimates.
— Commercial Real Estate Loans: Data on property types, debt service coverage ratios, geography and loan maturities was collected from the 19 banks, which was then used to generate independent loss estimates for each portfolio. For loans maturing in 2009 or 2010, regulators created a model comparing current loan-to-value ratios with various benchmarks "to assess the probability that borrowers would be able to refinance their exposure." The Fed noted that for construction loans, the geography and nature of the project received "special attention."
— Commercial and Industrial Loans: Regulators said they analyzed losses on C&I loans using internal ratings provided by the banks and a distribution of exposures by industry. This information was supplemented with external measures of risk chosen by supervisors.
— Securities In Banks' Portfolios: The Fed said regulators obtained significant data on private sector securities such as commercial and residential mortgage-backed securities. Information collected included details of each security's structure, collateral type, vintage and the type of property involved. Individual securities were then tested for possible impairment based on credit loss rates on underlying collateral, which were compared to the current credit support levels for the securities. Securities deemed to have insufficient credit support were written down to fair value, resulting in an "other than temporary impairment charge."
— Trading Portfolio Losses: Regulators said they applied market stress factors on the trading exposures for the five firms with trading assets over $100 billion. The stress factors were based on actual market performance from the final six months of 2008, and regulators used information from firms' internal risk-management reports to project loss amounts.
