Investors were hoping that Fed Chairman Ben Bernanke would seek to inject a measure of confidence into investors with his testimony today before the Senate Banking Committee. While Mr. Bernanke didn't exactly accomplish that, he did however open the door to optimism just a crack after saying that measures already taken by the Federal Reserve combined with the broad range of other fiscal and financial measures being put in place, will contribute to a gradual resumption of economic growth and improvement in labor-market conditions in a context of low inflation.

 

Although he did say the U.S. economy is in a “severe contraction,' he added if actions taken by the administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability -- and only if that is the case, in my view - - there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery,” Bernanke said in remarks to the Senate Banking Committee in Washington.

 

However, “downside risks probably outweigh those on the upside,” Bernanke said today in his semiannual testimony on the economy, adding that the Fed’s own forecast was clouded by “considerable uncertainty.”

 

He also provided more information regarding the government's new stress-tests, saying that the government’s bank-capitalization plan is designed to shore up lenders’ common equity only if the economy worsens and creates more losses for financial institutions.

 

The Treasury will buy convertible preferred stock as needed in the 19 largest U.S. banks only after such tests determine how much capital is needed to address losses in a “worse” case scenario. Seeking to downplay the possibility of nationalization, the possibility of which has severely hurt investor sentiment recently, Mr. Bernanke said shares will be converted to common only as the extraordinary losses happen, if they do.

 

“It doesn’t have an ownership implication until such time as those losses which are forecast in the bad scenario actually occur,” he said.

 

The chairman added that it will be up to Treasury Secretary Timothy Geithner and the Obama administration to determine whether more bailout funds will be needed from Congress.

 

“How much more we’ll have to do depends on the state of the banks, it depends on how the economy evolves and it depends on the margin of safety we think we want to have,” Bernanke said today. He separately warned that “if we don’t stabilize the financial system, we’re going to founder for some time.”

 

The stress tests “will look at the balance sheets and the capital needs of each of our 19 largest $100-billion-dollar-plus banks over the next two-year horizon,” Bernanke said in response to a question from Senator Robert Corker of Tennessee.

 

The assessment will use “both a consensus forecast -- where we think the economy is likely to be based on private sector forecasts -- and an alternative which is worse,” Bernanke said.

 

The purpose of the reviews isn’t to provide a “pass” or “fail” grade for banks. Instead, the government wants to ensure that banks can meet their obligation to lend even if the economy worsens, he said.

 

“The bank could convert the preferred to common to make sure that it has sufficient common equity, and only at that time, going forward, if those losses do occur, would the ownership implications become relevant,” Bernanke said.

 

Regulators won’t let banks “hide anything” as they look at how lenders have valued their assets, and will ensure that firms are using “appropriate models” for mark-to-market accounting, Bernanke said.

 

“We’re going to do a tough evaluation,” the central banker said in response to a question from Senator Richard Shelby of Alabama.