Call it the great equity chase: 10 banks, six months, $75 billion in capital to raise. Except that, as with so much in finance, this is no even competition. With the federal government's two-month "stress tests" for the big banks complete, and the results public, the market's attention is turning to just how the 10 banks found wanting will manage to improve their capital.
Some, no doubt, will have an easier time than others. Morgan Stanley (MS), told to come up with $1.8 billion in common equity, has announced plans to sell $2 billion in stock to meet the goal. Wells Fargo (WFC), with a $13.7 billion hole to fill, says it will sell $6 billion in shares and count on strong earnings, among other measures, to fill the gap. Bank of America (BAC) has the largest capital hole to fill: nearly $34 billion. The Charlotte-based bank said on May 7 it has several avenues to meet that goal, and would sell common stock and other assets, "and/or convert existing privately held preferred stock into common shares."
It remains to be seen just how receptive the capital markets will prove to buying stakes in banks that, many investors believe, are still weighed down with deteriorating mortgages and other loans. Those that get a chilly reception, however, could face a handful of unappetizing alternatives.
Consider GMAC, the auto lender whose fortunes have long been tied to General Motors (GM) and, more recently, other carmakers. Federal banking regulators concluded that the company, which also has heavy exposure to the mortgage market through its ResCap unit, needs to raise $11.5 billion to weather the government's worse-than-expected economic scenario.
GMAC will comply with the government's request that it raise capital, but says it is too soon to discuss how. A GMAC spokeswoman notes that some of the company's need for capital under the stress tests stems not from its loan performance but from its heavy reliance on a single customer, the troubled General Motors. "These are all assumptions and estimates under adverse scenarios," spokeswoman Gina Proia said late on May 7. "We, of course, fully intend to comply with that capital requirement, and in the end that capital raise is going to strengthen the company and enable us to continue lending."
But some analysts and investors argue that, if that worst-case scenario proves accurate, there's little reason for any private investors to sink a significant sum into the company. That's because the stress-test results released by the Federal Reserve on Thursday imply GMAC would be worth less than $11.5 billion by the end of 2010, even if it raised that much before then.
If a deep-pocketed investor "knew with certainty this scenario would happen, he'd be paying $11.5 billion for an institution that in two years would be worth $7 billion," says James Kwak, a former McKinsey consultant and co-author of the Baseline Scenario blog.
Quality of Capital
Federal officials emphasize that economic assumptions they made in the stress testing—about unemployment rates, loan deterioration, etc.—are worse than economists generally expect. But others have criticized those assumptions as too optimistic. So taking a stake in GMAC amounts to an expression of faith, Kwak says. "There's some chance this more adverse scenario will happen and you'll lose money, but there's some chance things will turn out better, in which case you may make money," he said in an interview.
Of course, other options are open to GMAC as well. It could seek to convert the more than $5 billion of preferred shares it has sold to the Treasury since December, under the government's financial stabilization program, into common shares. That would help improve what bank regulators call the quality of GMAC's capital—common equity comes with fewer strings than preferred shares—but it doesn't actually give the company a better financial cushion with which to absorb losses on the loans it has written. The conversion essentially just moves capital from one bucket to another. Moreover, the $6 billion in preferred shares likely wouldn't fill the full capital hole GMAC faces under the stress-test scenario. In that case, another option GMAC could pursue is selling the Treasury a new round of preferred shares, which the agency is calling mandatory convertible preferreds. Essentially, they convert to common shares when bank regulators decide it's necessary.
Of course, Treasury Secretary Timothy Geithner has made it clear that these big banks will get the capital they need. And GMAC is now financing dealers and auto sales at Chrysler, while that company is in bankruptcy—giving Uncle Sam yet another stake in GMAC's health.
Francis is a correspondent in BusinessWeek's Washington bureau.