Will stress test push Citi to raise $10 billion?

Unless the date is delayed again, this Thursday the U.S. will announce the results of its bank stress tests for 19 TARP recipients -- and a report from FBR suggests that 14 of them will need to raise new capital. And reportedly, the U.S. is demanding that Citigroup, Inc. (C) raise $10 billion, a demand about which they are squabbling. As I posted, the stress tests are flawed and the U.S. should replace them with viability tests.

The U.S. probably thought that stress tests -- in which the U.S. tries to guess how much money each of the 19 banks will lose by plugging possible economic contraction and unemployment figures into a spreadsheet -- would be clever.

But as I explained last month, the U.S. simply does not know enough about each bank to be able to do that with any credibility. Now banks are disputing the government's estimates -- which after nearly bringing the global financial system to its knees -- is actually making the banks look better than the government. (And I just learned that Warren Buffett shares my skepticism about the stress tests.)

In Citi's case, the amount of capital it needs to raise is in dispute. And Citi believes that it can raise the required money through sales of some of its assets and a big stock conversion plan. Specifically, Citi is selling its Nikko Cordial Securities to Japan's Sumitomo Mitsui Financial to boost Citi's tangible common equity -- a capital measure which the U.S. expects banks to maintain no lower than at 4 percent of assets -- by $2.5 billion. Citi also plans to split-off Smith Barney and to convert some of the government's $45 billion preferred stock investment into common stock.

But will these moves raise enough tangible common equity to satisfy the stress testers? Initially, none of those actions counted in the preliminary stress test results that regulators revealed to the banks last week. But now regulators are allowing the banks to adjust those figures based on their actual first-quarter performance.

If this flawed process is supposed to inspire investor confidence I am not sure it's working. After all, some of the 19 banks will probably pass the stress test and they will enjoy a rise in their stock prices because they'll probably get new customers who flee the banks that fail the stress tests. Eventually the healthiest banks will pay back the TARP money and then be free to pay their people as much as they want -- which means they'll poach talent from the banks that can't repay the TARP.

This is why I argued last month that we should require these banks to produce a viability plan -- like the ones that the auto industry was required to create. If that happens, the banks will own the results instead of quibbling with the government and creating confusion. If the banks can't show how they'll be able to survive, then we can fashion a plan to euthanize them in on orderly manner.

Peter Cohan is president of Peter S. Cohan & Associates. He also and is the author of You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He owns Citi shares.

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