News Analysis May 12, 2009, 12:01AM EST

Behind the Bank Equity Blitz

Do bank stress tests and the latest round of capital-raising mean it's finally safe to invest in financial stocks?

Story Tools

The last week has been a Rorschach test for investors. Bearish investors question the assumptions and results of government-conducted stress tests, which required top U.S. banks to raise billions in new capital. Bullish investors cite realistic hopes that this round of capital-raising could signal an end to the financial crisis.

At first the bulls seemed to win the day, with financial stocks helping to lead the market higher last week. Then, on May 11, bank stocks gave up some of their gains. So is it really, finally, safe to invest in financial stocks?

There's no doubt that something has changed. In just a few days, institutions from U.S. Bancorp (USB) and Wells Fargo (WFC) to Keycorp (KEY) and Capital One Financial (COF) have been able to raise billions—not from the government but from private investors.

A long crisis of investor confidence appears to have ended, at least temporarily, from a combination of stress test results, a stabilizing financial and economic situation, and the passage of time. "It's showing investors are regaining some confidence in the banks," says Mark Batty, an equity analyst at PNC Capital Advisors (PNC). "That's a positive for the system overall."

Still, bank stocks retreated on May 11 after a strong rally in the past two months that saw many financial equities double in price. Batty thinks an oversupply of new shares on the market may be to blame. Indeed, banks are offering equity shares not just because they were required to do so (by the results of government stress tests), but because they want to.

Paying back TARP bailout cash

U.S. Bancorp, which got a clean bill of health from its stress test, offered $2.5 billion in common stock on May 11. Although the offering dilutes the stakes of current shareholders, it is part of the bank's plan to pay back $6.6 billion it owes the government through the U.S. Treasury's Troubled Asset Relief Program, or TARP. Getting out from under TARP is a top goal for many banks, though some market observers question their motives.

TARP bailout funds had strings attached, including limits on employee compensation. "It's in management's interest to get out of [TARP] so they can pay themselves more," says Standard & Poor's equity analyst Stuart Plesser. One disadvantage of leaving TARP: The government says it will withdraw guarantees on debt issues, which could hurt profitability, Plesser says.

But leaving TARP could have its pluses, Plesser and others say. "The companies that can emerge from TARP and just get the government out of their lives are going to have a significant competitive advantage," says Uri Landesman of ING Investment Management (ING). Non-TARP banks might better be able to retain and attract talented employees, Landesman says. And even if that's not true, he says, "that's going to be the perception of customers."