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It’s a leak free-for-all ahead of the stress test release, and it’s a little difficult to sort out what’s going on. Citigroup and Bank of America are apparently asking the government to conclude that they need no new capital while simultaneously looking to raise upwards of $10 billion each. Meanwhile the administration is preparing to release more detailed information than had been anticipated, but we also have a senior government official saying, “None of these banks are insolvent,” according to the tests.

But it actually seems to me that an endgame is emerging. As Warren Buffett says, the market is increasingly confident in banks not named Citigroup (I’d add Bank of America). The administration probably wants to use the stress tests to sound the all clear for most of the nation’s big banks, helping them to recapitalize primarily from private sources. The tests will show that Bank of America and Citi are “solvent,” but their capital needs will be sufficiently great that private sources of funding will be thinner. And then the fun begins. Here’s David Leonhardt:

The banks whose reserves are judged insufficient — Bank of America, Citigroup and a few regional banks lead the list of likely suspects — will be given six months to shore up their position, before being required to accept government money. The most obvious ways to do so will be to find new investors willing to buy a stake or to persuade existing owners of preferred stock (which is akin to a loan) to renegotiate their stakes.

Another possibility is that the government may encourage significant cost-cutting. That could lead to layoffs and leave some of the world’s largest companies far smaller than they once were. Last week, Citigroup agreed to sell a brokerage firm to a Japanese financial group, largely to raise capital.

And Francesco Guerrera:

Citi is believed to be considering a plan to convert more than $15bn in trust preferred shares – a hybrid of debt and equity – into common stock. Since trust preferred shares are held by non-government investors, this conversion could enable the authorities to inject further funds into the bank without raising its stake beyond the 36 per cent it has already agreed to buy. People close to Citi say it would have to force holders of trust preferred shares to convert them into common stock, which ranks below those securities and does not pay a yearly interest rate, by threatening to stop paying interest if they reject the offer.

This looks very similar to the approach to the automakers. Give the problem banks deadlines. Prop them up in the mean time while encouraging them to slim down and squeeze stakeholders, and generally lay the groundwork for something like a bankruptcy (or receivership). The six month deadline could explain why Geithner isn’t that upset about Barney Frank’s slow moving on the regulatory reform bill in Congress (which would include procedures for receivership).

The big question to me is where this leaves PPIP. Hank Paulson eventually gave up on asset purchases after concluding that he didn’t have enough dough to do equity stakes and purchase assets in sufficient quantity to make a difference. I wonder if Geithner isn’t moving the same way, thinking that a clean bill of health will let markets do the recapitalizing of most banks, allowing Treasury to keep its remaining TARP money for the really sick banks.

Source: Stress Test Leaks: Endgame Emerging