US banks told: prepare for 47% drop in house prices

The US Treasury told the country's major banks they must ensure their capital levels can cope with a severe recession, including unemployment over 10% and an overall 47% drop in house prices from their peak in 2006.

The Treasury and the Federal Deposit Insurance Corporation (FDIC) announced more details of the Capital Assistance Plan (Cap) yesterday, outlining for the first time the two stress scenarios it will use to assess capital adequacy in the 19 largest US banks.

The 'baseline' scenario for the US economy, based on an consensus of economic forecasts and housing index futures prices, involves a recession lasting until the end of the year, with unemployment peaking in 2010 at 8.8%. Under this scenario, house prices, measured by the Case Shiller 10-City Composite index, would fall 14% this year and another 4% next year - by the end of 2010, this would represent a 39% drop from the peak in mid-2006.

However, under the more adverse scenario, the economy would shrink 3.3% this year and only return to growth in mid-2010. Unemployment would rise over 10%, averaging 10.3% in 2010, and house prices would fall 47% below their 2006 peak, a level last reached in 2001. There is "a roughly 15% chance" the future will be as bad as this or worse, the FDIC said.

The tests will be compulsory for the 19 US banks that have more than $100 billion in assets - together, they hold roughly two-thirds of the total system's assets, the FDIC said. By the end of April, they should have completed the tests and decided whether either scenario would require them to hold additional capital.

If additional support is needed, the banks have six months to try to raise the capital from private investors, after which they will be able to receive contingent capital from the Cap, in the form of convertible 9% preference securities.

These securities give the company only a limited respite - they must be redeemed within seven years or the government will be able to forcibly convert them into common stock, which, depending on the amount of capital received, could give the US government a significant or even a controlling stake.

The Treasury said earlier this week that it did not expect the baseline scenario stress test to lead to any additional capital requirements, but that it might be needed under the more severe test. The securities can be converted at will by a bank to raise its core capital levels. The conversion price will depend on the time of conversion: initially 90% of the average for the 20 trading days to February 9 this year, it will drop by 15% every six months to a minimum of 55%.

"To the extent that a significant government stake in a financial institution is an outcome of the programme, our goal will be to keep the period of government ownership as temporary as possible and encourage the return of private capital to replace government investment," the Treasury said. "Government holdings in banks will be managed in a separate trust with a mandate to "protect and create value for the taxpayer as a shareholder."

The stressed scenario is similar to that used by JP Morgan earlier this week to justify its decision to cut quarterly dividends - chief executive Jamie Dimon said: "We must necessarily be prepared to handle a highly stressed environment (although we are not predicting this)," and described a two-year contraction that assumed unemployment would exceed 10% and house prices would fall 40% from their peak.

See also: JP Morgan cuts dividend to build capital reserves
CAP details expose transatlantic split on capital