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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.
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."
Paying back the government will be a mark of strength. It could be a sign—for investors and customers—that a bank is healthy and has beaten its financial troubles, Landesman says. Plesser, however, warns that many of the strongest banks—those, such as U.S. Bancorp, most likely to pay back TARP funds—have shares selling at expensive prices on the stock market.
No matter what the stress tests say, it may be too early to call any U.S. bank healthy. As New York University professor Nouriel Roubini put it May 8: "The stress tests are not stressful enough." The results "significant[ly] underestimate [banks'] capital/equity needs."
Interpreting stress test results is a subjective process. Investors can't examine the Federal Reserve's calculations in detail, nor look deeply into the quality of the items on a bank's balance sheet. "Nobody outside the institution understands the quality of [a bank's] assets," says Larry Tabb, chief executive of TABB Group.
Since that part of the stress test is so difficult to evaluate, investors must look at the broader economic assumptions built into the stress tests. For example, the tests assumed that the unemployment rate hits 10.3% in 2010. The future of banks "really depends on what happens with the economy," Tabb says. Roubini, however, assumes the jobless rate will reach 10.5% by the end of this year and exceed 11% in 2010.
As usual, economists disagree, but recent jobs data have not eased concerns. "The high and still rapidly rising rate of unemployment remains the Achilles' heel of the economic recovery," John Ryding and Conrad DeQuadros of RDQ Economics wrote on May 8.
For banks, "it's still a difficult road ahead," says Quincy Krosby, chief investment strategist at the Hartford (HIG). Among the worries—ll linked to the state of the broader economy—are "collateral damage from credit-card debt, commercial debt, and housing market foreclosures," she says.
S&P's Plesser says his focus is shifting toward employment trends and away from home prices. The housing market had a large impact on subprime losses, but further losses could come from prime loans, credit cards, and commercial loans—all closely linked to the jobless rate. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies.)
The bank stress tests—and the initial success of recent capital-raising—settle at least some investor questions. Investors are in a much better mood than during the depth of the crisis, and nationalization of banks is unlikely. But all indications suggest that the financial sector will remain an extremely stressful place to be an investor.
Steverman is a reporter for BusinessWeek's Investing channel.