Just as the prospects for bank stocks can't seem to get any worse, they do.
To the all-too-real problems of the financial crisis and recession, add another serious concern: A U.S. government bailout may prop up the financial system and save big banks from collapse, but it may prove disastrous for bank shareholders.
With shares of Citigroup (C), another troubled banking giant, dropping 20%, financial stocks were responsible for much of the stock market rout on Jan. 20. The Dow Jones industrial average lost 332 points, or 4% of its value, while the broad Standard & Poor's 500-stock index, with a heavier concentration of financial stocks, lost 5.3%.
Investors were clearly worried about mounting problems for banks, exemplified in recent earnings reports that show huge increases in problem loans and billions more in investment losses.
Cure for a "Bankrupt System"?
New York University Professor Nouriel Roubini, who foresaw the credit crisis, heightened investors' panic when Bloomberg reported on Jan. 20 that he estimated credit losses for U.S. firms could hit $3.6 trillion. Thus, the U.S. banking system—with just $1.4 trillion in capital—is "effectively insolvent," Roubini said, according to Bloomberg. "The problems of Citi, Bank of America, and others suggest the system is bankrupt," he added.
The supposed cure for this is the federal government's $700 billion Troubled Assets Relief Program, or TARP, enacted late last year. However, a growing number of investors and analysts warn that the TARP program may come at a large cost to bank shareholders.
Banks get TARP relief only by giving the federal government preferred shares. On Jan. 16, BofA issued the government another $20 billion in preferred stock that pays an 8% dividend. In exchange, the government agreed to limit future losses on $118 billion in BofA investments, including a large amount of the portfolio acquired through BofA's buyout of Merrill Lynch.
"Increased support by the U.S. government provides protection on certain problem assets," notes Deutsche Bank (DB) analyst Mike Mayo, but "it also comes with more restrictions on [BofA] as a whole."
TARP Payments Jeopardize Dividends
There are three main concerns about the government's rising stake in banking firms like BofA, says Stifel Nicolaus (SF) analyst Christopher Mutascio.
First, there is the size of dividend payments due to the government each year, which leave little remaining for regular shareholders. On Jan. 16, BofA slashed its first-quarter dividend to just 1¢ per share. Meanwhile, Mutascio estimates the preferred dividend payment to the U.S. Treasury will be $4.8 billion per year. That's 73% of the total net income he expects from BofA in 2009.
FBR Capital Markets (FBR) analyst Paul Miller estimates preferred dividends could shave 90¢ per share off BofA's annual earnings "for the next three years at least."
Second, the TARP program's investments must eventually be paid back. At BofA, the government's equity stake is $49 billion. After the stock's disastrous drop on Jan. 20, the government's equity stake is almost twice the public market capitalization for the bank of $25.6 billion. To repay TARP money, Mutascio warns, banks may need to issue new public shares, which would greatly dilute current shareholders' stakes.
Who Calls the Shots?
Finally, there is the power that the TARP investment gives federal policymakers over bank operations.
With so much of BofA owned by the taxpayers, "we are concerned that common equity is no longer the dominant form of capital at Bank of America," FBR's Miller warned on Jan. 20.
"It is reasonable to assume that political pressure will only mount on [BofA] to do things that may not be in the best interests of its common shareholders," Mutascio wrote on Jan. 20. The arrival of the Obama Administration only adds to the uncertainty.
Standard & Poor's equity analyst Erik Oja raised his rating on shares of BancorpSouth (BXS) in part because the regional bank hasn't needed to take TARP funds. Banks don't know all the disadvantages of taking the TARP bailout, Oja says, because "the government does reserve the right to tweak some of the rules going forward."
For example, analysts warn banks may be forced by the government to loan out money. That may help the U.S. economy recover more quickly, but it could hurt bank balance sheets if they're forced to lend to people and businesses just as their finances are being hurt by a serious recession.
In some cases, banks could be forced to eliminate dividends to common shareholders, Oja warns. While others could be forced to boost lending, even though it's difficult to find creditworthy borrowers in a recession. "Taking that money and putting it to work right now is tough," Oja says.
According to a Keefe, Bruyette & Woods (KBW) analysis, 262 firms have announced they've received TARP capital. Another 121 institutions say they won't seek bailout funds. Most of those refusing TARP money are smaller regional banks, including BancorpSouth, New York Community Bancorp (NYB), and Union Bankshares (UNB).
Investment Pariah or Buying Opportunity?
Many of those who took TARP money simply had no choice as credit losses mount. Those losses remain banks' biggest concern, because they are the reason banks must seek federal bailouts despite the strings attached and the disadvantages to shareholders.
"Credit losses are the key to earnings for any financial company," Miller says. Losses in the housing market, commercial real estate, and other investments and loans are leaving banks dangerously short of capital, analysts warn. "We would avoid not only [BofA's] shares, but also shares of most financial institutions until the companies are better capitalized," Miller adds.
Some analysts look at the cheap stock prices for major banks and see buying opportunities.
Raymond James analyst Anthony Polini rates Bank of America a "strong buy." The bank's "core" annual earnings power is something like $4 per share. "Although it may take three or four years to regain this level of earnings, longer-term investors should be well rewarded for their patience," Polini writes.
One of those long-term investors is the U.S. taxpayer. The Congressional Budget Office on Jan. 16 estimated that, using one method of analysis, the U.S. Treasury's $247 billion in TARP investments made as of Dec. 31 have lost 25% of their value.
Uncle Sam, like ordinary stockholders, can only watch, and wince.
Steverman is a reporter for BusinessWeek's Investing channel.