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Buddy, can you spare a billion?

As housing prices and share prices keep falling, mortgage-heavy banks that need new capital may find few willing investors.

By Roddy Boyd, writer
Last Updated: July 15, 2008: 3:06 PM EDT

NEW YORK (Fortune) -- Investors who made bets on a turnaround in bank stocks are smarting now. And that's going to make it tough for banks facing more real estate writedowns to raise new money in the coming months.

One investment firm spending a lot of time at the medicine cabinet is TPG Group, the Fort Worth-based private equity giant, with $50 billion in investments. It seems likely that Chairman David Bonderman would like about $2 billion of it back, having injected that sum into Washington Mutual (WM, Fortune 500) back in April as part of a $7 billion capital boost for the mortgage-heavy Seattle thrift. The firm now holds a 16.2% stake in WaMu.

Despite receiving a discount to the then-current share price and a series of eye-poppingly favorable provisions that protect its investment, TPG has lost big on WaMu. The bank's shares are fetching less than $4, down from $13.15 when TPG made the investment.

And the $3.80 price a WaMu share fetched in midday trading Tuesday marked a sharp improvement over Monday's close. The rebound came after WaMu issued a press release arguing that it was well capitalized, with $40 billion in liquidity available.

Whether that ultimately will be enough is an open question. WaMu holds a massive concentration of loans to Florida and California homeowners. Those markets are in a free fall. For example, prices are down 27% over the past year in Miami, according to the S&P Case-Shiller index.

Moreover, WaMu has $57 billion worth of so-called option adjustable rate mortgage securities on its books, considered one of the most problematic mortgages with respect to repayment. Option ARMs gave borrowers the opportunity to make monthly payments so low not even interest costs were covered.

The secondary market performance of option ARM debt over the past six weeks has been disastrous, with most ARM paper is trading between 50 and 65 cents on the dollar.

Lehman Brothers, in a report Monday, argued that WaMu may need to make loan loss provisions of up to $26 billion in all to cover the cost of loans gone bad.

Yet WaMu's options for raising new capital are complicated by a provision in its TPG agreement that forces the thrift to compensate the private equity shop for diluting its holdings if the bank raises more than $500 million, or sells stock below $8.75 a share.

Last month, WaMu announced it would no longer offer option ARMS. A TPG spokeswoman declined comment.

"Bleak" prospects

If the ARM business has been painful for TPG and WaMu, it's been even worse for investors in Wachovia (WB, Fortune 500). The Charlotte, N.C., bank has a portfolio of $130 billion in option ARMs as a legacy from its so far ill-fated $24.2 billion purchase of San Francisco thrift Golden West Financial in 2006.

Wachovia's stock took its latest drubbing Tuesday when high-profile analyst Meredith Whitney of Oppenheimer contended that the bank's shareholders have "bleak" prospects. Whitney suspects another dividend cut may be in the offing.

Wachovia has taken sharper actions to right its ship than has WaMu. In April, it raised $8.025 billion via the sale of equity and preferred stocks and forced the resignation of the chief executive who did the Golden West deal, G. Kennedy Thompson. Last week, the bank hired former Goldman Sachs partner and Treasury under-Secretary Robert Steel. Meanwhile, WaMu continues to be led by longtime chief Kerry Killinger.

According to CreditSights, Wachovia may be forced to take an additional $7.1 billion in writedowns, after reporting $13.7 billion in losses so far. A Wachovia spokeswoman said the bank is well capitalized and on solid footing.

Crowded field

The real problem for banks like Wachovia and WaMu isn't that they are in the roughest shape of their peer group; it's clear they're not, at least in Wachovia's case.

The problem is that the market for raising capital is getting mighty crowded. Giant brokerage Merrill Lynch (MER, Fortune 500) is said to be peddling crown jewels like its Bloomberg L.P. stake. And as troubles in the debt markets continue, Citigroup (C, Fortune 500) and others might be forced to rattle the cup again.

Private equity firms and pension funds have seen massive drops in the value of their financial sector bets, and according to investors and bankers Fortune has spoken to, aren't looking to add to their U.S. banking and brokerage exposure.

Sovereign wealth funds the world over have been very responsive to name-brand companies like Merrill, Citi and Morgan Stanley (MS, Fortune 500), and for their interest, they have seen staggering losses. Even with oil fetching $140 per barrel, funds in Kuwait, the United Arab Emirates and Saudi Arabia surely have a limit to their appetite for pain.

That leaves old fashioned money managers as a source of capital. There is likely some potential interest in bottom-fishing in certain quarters, but the big mutual and hedge funds have taken body blows in playing the financial sector - Alliance Bernstein, the biggest owner of Fannie Mae (FNM, Fortune 500) and Freddie Mac, has lost hundreds of millions on those investments alone over the past two weeks. That will likely make potential buyers of beaten down bank stocks very leery. To top of page