No stress for bank stocks

Investors embrace Bank of America and rivals such as Wells Fargo - even as big capital-raising moves loom as a result of the bank stress tests.

By Colin Barr, senior writer

FDIC chief Sheila Bair is among the policymakers overseeing the stress tests.

NEW YORK (Fortune) -- The stress test results are starting to leak out, and even banks with middling grades are being treated as winners in the marketplace.

According to several reports out Wednesday, Bank of America (BAC, Fortune 500) is the biggest loser so far of the 19 banks that took part in the government's Supervisory Capital Assessment Program. The results of those stress tests are due to be released to the public tomorrow afternoon.

Regulators reportedly have told BofA it needs $34 billion in additional common equity -- which it can raise by selling shares or assets, or converting preferred shares to common stock -- to make sure it keeps lending through the recession.

But you'd never know BofA was a stress test dunce by looking at trading Wednesday. The stock soared 18%, even though the stress test results suggest the bank's shareholders can expect to see their investments diluted in coming months.

The gains add to a two-month-long rally in the sector. That bounce could offer banks that do need to raise capital -- a group that analysts expect to include giants Citigroup (C, Fortune 500) and Wells Fargo (WFC, Fortune 500) as well as PNC (PNC, Fortune 500) and numerous other regional banks -- an opportunity to do so without necessarily bringing the government in as a big common stakeholder.

Shares of Citi, Wells and PNC all rallied as well Wednesday.

"Banks will most likely bolster their capital levels by converting preferred equity (including TARP) into common equity, as it is the cheapest and easiest route," FBR Capital analyst Paul Miller wrote in a note to clients Tuesday. "However, we encourage banks to use the recent market rally to raise capital in the open market."

While $34 billion is a big number for BofA, it's not a surprise as far as Wall Street is concerned. The bank has already received $45 billion of federal aid.

Two analysts who have been following the stress tests, Miller of FBR Capital and Keith Horowitz of Citigroup, had estimated BofA would need $31 billion and $33 billion, respectively.

Four of the 19 banks that were stress tested -- JPMorgan Chase (JPM, Fortune 500), credit card issuer American Express (AXP, Fortune 500), financial custodian Bank of New York Mellon (BK, Fortune 500) and investment firm Morgan Stanley (MS, Fortune 500) -- won't need to raise any new capital, according to reports Thursday. Other reports have indicated that more than four banks passed the test, however.

Going by the estimates Miller and Horowitz have released, the big bank that may have the most to worry about other than BofA is Wells Fargo, the San Francisco lender that seems to be Warren Buffett's favorite bank.

Buffett spent the past weekend talking up Wells at his annual meeting of Berkshire Hathaway (BRKA, Fortune 500) shareholders in Omaha. At various points he called Wells "fabulous," extolled its competitive advantages over rivals and said he would like to own the whole company, if it weren't for rules that prevent him from doing so. Berkshire is Wells' largest shareholder.

In an interview last month with Fortune, Buffett dismissed the usefulness of measuring common equity -- the number the stress testers seem to be focusing on most intently as a gauge of a bank's ability to withstand losses in a down cycle in the economy.

"What I pay attention to is earning power," Buffett told Fortune's Adam Lashinsky. "Coca-Cola (KO, Fortune 500) has no tangible common equity. But they've got huge earning power. And Wells ... you can't take away Wells' customer base."

Of course, no one is proposing to take away Wells' customer base, and the bank noted in its first-quarter earnings report last month that it made $9 billion in the first quarter, before taxes and credit loss provisions.

Even so, both Miller and Horowitz expect the bank -- which has a big home equity portfolio and sizable exposure to construction and industrial loans that are expected to be hit hard over the next year -- to be forced to raise more than $20 billion. Bloomberg News reported Wednesday that Wells will have to raise $15 billion in common equity.

While Miller says many banks will be tempted to convert their TARP preferred stock to common shares, that won't be the only option for banks. Horowitz, for one, expects both Bank of America and Wells to convert preferred shares held by private stockholders to common stock.

Others have suggested Bank of America could sell some shares in a Chinese bank to raise cash.

Regardless of how the banks get to their new capital targets, current shareholders can expect to foot much of the tab, through the banks' issuance of new common shares. Even so, some analysts say the cheapest banks could still look attractive.

Even with pending dilution, Bank of America - whose shares were down more than 90% over the past year at their Feb. 20 low - "looks like the cheapest in the group," Horowitz said. To top of page

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