Stress tests may force banks to convert TARP stock

US banks that received results of their federal stress tests last week were given three options if they need additional capital to withstand the recession. The reality is they may only have one.

Getting federal aid or selling shares – two of the choices offered to the 19 lenders being tested – aren’t practical politically or financially, according to analysts, including Jeff Davis, the research director at Howe Barnes Hoefer & Arnett in Chicago.

Lawmakers have opposed adding more to the $700 billion that the government already committed and investors have balked at buying shares of financial firms after a two-year drop.

 

That leaves the third option presented by US Treasury Secretary Timothy Geithner: changing the preferred stock held by the US Troubled Asset Relief Programme (TARP) into common shares. Doing so would prop up capital under accounting rules and dilute the value of shareholdings for current investors.

SunTrust Banks, KeyCorp and Regions Financial Corp, pegged by Morgan Stanley last week as the “most likely” to need capital, dropped more than 70 per cent in New York Stock Exchange composite trading during the past year. Shares of the three companies were indicated lower in Germany today.

“The best most can hope for is to stay as they are and not be forced to draw down still more TARP capital or convert what they’ve got into common stock,” said Karen Petrou, managing partner of Washington-based research firm Federal Financial Analytics.

TARP tapped out
Bank executives received preliminary results from the US Federal Reserve reviews on April 24. The stress tests aim to identify potential losses and how much capital banks will require should the economic slump worsen in the next two years.

Geithner can’t ask for more money from the US Congress, which may force banks that need funds to convert the government’s preferred holdings into common equity, said Davis, whose firm tracks the financial services industry.

Lawmakers have said they oppose allocating more money for TARP because of the high costs, lack of disclosures on how the money is being used and concerns about bonuses paid to executives of money-losing companies, including American International Group and Merrill Lynch.

Lenders that need funds will be able to obtain money through the government or private sources, White House Chief of Staff Rahm Emanuel said in an April 24 interview. Emanuel said that the US Treasury has enough left from the original sum, and Geithner said on April 21 that $109.6 billion remains in TARP, or $134.6 billion including expected repayments in the coming year. The US Federal Reserve, which oversaw the stress tests, wants common equity to be the “dominant” element in a bank’s capital. The US Fed didn’t specify a particular target for a bank’s ratio of tangible common equity, or TCE, to tangible assets.

TCE is a measure of a bank’s financial health that excludes intangibles such as brand names that can’t actually be used as payments. Investors and analysts have focused on the ratio as a more accurate benchmark of a bank’s ability to absorb losses.

The industry was examined as bad assets soared 169 per cent from a year earlier at 13 of the largest US banks, according to first-quarter data compiled by Bloomberg. US unemployment rose to 8.5 per cent in March, the highest since 1983, as the economy shed 663,000 jobs. The stress test examined a bank’s capital adequacy assuming unemployment rises as high as 10.3 per cent in 2010 and home prices drop as much as 7 per cent.

Trillion-dollar projection
The US Fed study focused on loss projections for consumer, commercial, industrial and commercial real estate loans, and on the securities that banks hold. Analysts at New York-based KBW, led by Frederick Cannon, said banks may require another $1 trillion of capital to cover losses as the economy deteriorates.

Banks were given preliminary results last week, with a final report to be published on May 4. The 19 firms include Citigroup, Bank of America, Goldman Sachs Group, GMAC LLC, MetLife and regional lenders, including Fifth Third Bancorp and Regions.

Representatives of the banks either couldn’t be reached this weekend or declined to comment.

Financial stocks rose on April 24 even as the US Fed stopped short of indicating how much new money regulators will demand that banks raise. The report said “most” companies have capital “well in excess” of regulatory requirements; it didn’t specify how the stress tests may affect those levels.

Senior executives and directors may find their jobs are at stake, depending on their cash needs. Geithner had said on April 5 that regulators may change management at any company that needs “exceptional assistance.”

Merrill’s loss
Bank of America Chief Executive Officer Kenneth D Lewis had said on March 12 that his company won’t need more taxpayer help after two sales of preferred stock to the US totaling $45 billion and $118 billion in federal asset guarantees to help absorb losses from the January 1 acquisition of Merrill Lynch.

Lewis, 62, is under fire for not telling shareholders that Merrill Lynch’s fourth-quarter losses were spiraling past $15 billion before they voted to approve the takeover.

The losses led to the second sale of preferred stock to the US in January, adding to the amount of potential dilution for shareholders.

Investors groups are calling for Lewis’ ouster at this week’s annual meeting, or for his role as chairman and CEO to be split. Directors are concerned the vote may be close, people familiar with the matter have said.

“People look at the stress test as a way of identifying who’s going to get more government money and more government control,” said Jeff Berman, a New York-based partner at law firm Clifford Chance LLP.