As banks receive their stress test results, some are finding that their only choice for survival could be converting TARP preferred shares to common shares, similar to what Citigroup (C) was forced to do. While banks were given three options -- sell shares, convert shares, or get more federal aid -- in reality, only one option truly exists if the stress tests show a bank needs to improve its capital position.
Banks likely won't have the option to sell shares because who would buy shares in a bank showing shaky results of the stress test? While it may be possible to find a cheap price investors would consider, it may not be any better than the conversion of the TARP preferred shares.
Congress clearly does not want to approve any additional money for TARP, so getting more federal funds also may not be a real option for the banks. Congress and the public want more disclosure about how the money is being used before thinking about additional funding. Since the Treasury Department and the banks have been reluctant to release additional information, additional federal funding is not an option. In addition, compensation and bonus issues continue to hurt any chance of getting new federal funding.
This leaves the banks in trouble with only one true option -- agreeing to the conversion of the preferred shares to common shares. But is that just a back door to nationalization? Some believe it is. By doing this, the banks can prop up their capital under accounting rules, but not dilute the value of shares for current investors. Also, banks that convert shares to common stock, won't be obligated to pay the preferred dividends, thus reducing their cash outlay. Still, the U.S. government will become one of their largest shareholders. What type of control will the government want over a bank's actions once it owns a controlling stake?
Morgan Stanley (MS) believes that SunTrust Banks (STI), KeyCorp (KEY), and Regions Financial Corp (RF) are the ones most likely to need capital. Shares in these banks have lost about 70 percent of their value in the past year.
Bad assets have soared 169 percent over past year at 13 of the largest U.S. banks, according to first quarter data from Bloomberg. With U.S. unemployment at 8.5 percent, its highest rate since 1983, bad assets will likely rise. The stress tests looked at bank capital needs if unemployment rose to 10.3 percent in 2010 and home prices dropped 7 percent.
Many economists believe an unemployment rate of 10 percent or more is possible before we see an improvement in the labor market, meaning these tests appear to have been realistic. The big question is -- if a bank fails this test, is it worth saving at all?
Lita Epstein has written more than 25 books, including Reading Financial Reports for Dummies and the Complete Idiot's Guide to Value Investing.