Fix the bank

EVEN AFTER CITIGROUP'S HIGHLY DILUTIVE DEAL with the government on Friday, battered bank stocks managed to end the week up 11%, well above the lows set Feb. 20. One reason is that guidelines for the government's "stress test" for banks, unveiled Wednesday, proved less onerous than expected. A second reason is that capital levels at the nation's regional banks now look fairly sturdy.

The Citi deal has everyone on Wall Street suddenly talking about a measure of financial strength called tangible capital, which is a bank's tangible common equity divided by its tangible assets. Citi (ticker: C) ranks as one of the worst institutions by this measure, with a tangible-capital ratio of 1.5%. Now that Citi has announced that the government and private investors will have the opportunity to convert their preferred shares into common shares, Citi's tangible capital ratio looks likely to jump to 4%. Many analysts and investors think 4% will emerge as the government's targeted minimum.

Prior to the Citi deal, regulators had focused on Tier 1 capital, which includes preferred stock and has been criticized for overstating banks' financial strength.


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Citi's Tier 1 capital appears healthy at 11.9%, double the regulatory minimum despite the bank's major problems. Because all Tier 1 capital cannot be easily used to absorb losses, investors are looking beyond that measure to tangible common equity. Now it appears that regulators are doing the same.

As shown on the table below, the change shouldn't pose a problem for many of the nation's large regional banks, many of them with tangible-capital ratios exceeding 5%.

Among the largest banks, JPMorgan Chase (JPM) is nearly at the 4% threshold, with a tangible-capital ratio of 3.8%. JPMorgan could easily hit the 4% mark by building capital over time. It took a step in that direction last week, announcing plans to cut its dividend 87%. This should add $5 billion to Morgan's tangible capital this year, pushing it to the 4% mark.

The new emphasis on tangible capital is a thornier issue for Bank of America (BAC), with a 2.6% tangible-capital ratio, and Wells Fargo (WFC), with a 2.8% ratio. Like Citi, they could meet a 4% minimum by having the government or private investors convert some preferred shares to common. The problem is that such a conversion would leave current holders of common stock owning less of Bank of America and Wells Fargo.

Table: A Capital DebateFears of this dilution pushed Bank of America stock down 25% Friday to 3.95, while Wells shares fell 16% to 12.10.

Executives at both BofA and Wells have said they don't see the need to raise capital right now, and there may be merit to that view. They could argue that their assets have already been marked down in value more than the assets of other banks, in part because Bank of America recently acquired Merrill Lynch and Wells acquired Wachovia. Indeed, Merrill Lynch marked its assets down substantially before selling itself to Bank America, while Wells took large write-downs of Wachovia's assets while completing the acquisition.

What does all this mean for investors? For the brave and the bold, it could mean opportunity. Given many false dawns for bank stocks in the past year, it is hazardous to call a bottom. But there is a case to be made that last week's rally in bank stocks could continue. Most banks look inexpensive, based on the ratio of their stock prices to tangible book value, a conservative measure of shareholder equity that excludes goodwill from acquisitions. A sizable slice of the industry is trading below tangible book value for the first time since 1990, including Bank of America, Capital One (COF), KeyCorp (KEY), SunTrust Banks (STI) and Comerica (CMA).

No question, bank profits will be depressed this year, and perhaps into 2010, with many institutions showing losses in 2009, as banks set aside reserves for growing loan losses. Some investment pros are steering clear of the group in favor of other depressed financial outfits, including asset managers and insurers.

Dividends, once hefty throughout the banking sector, are likely to be trimmed, as even relatively strong institutions reduce payouts to bolster capital. Analysts say dividend cuts are possible at Wells Fargo, U.S. Bancorp (USB) and PNC Financial (PNC). Oddly enough, JPMorgan's dividend cut didn't hurt its stock. Investors have become less focused on dividends than financial strength, particularly tangible book value. Anything that enhances book, including a payout cut, has come to be seen as a plus.

Four banks -- Bank of America, Citigroup, JPMorgan and Wells Fargo -- now dominate the industry, with combined assets of $7 trillion. No. 5 PNC has less than a quarter of the assets of No. 4 Wells Fargo. Bernstein analyst John McDonald's favorite megabank is JPMorgan, because it has a very "attractive risk-reward" ratio. It is trading at 23, just above its tangible book of $22. McDonald thinks JPMorgan's profit in 2011, the year that many analysts have targeted for a full-fledged economic recovery, could top $4 a share. His one-year price target is $38.

Among JPMorgan's most valuable assets is Jamie Dimon, arguably the best chief executive at any big financial company. Such praise, however, might be going to Dimon's head. In announcing the dividend cut Monday, he lauded his bank's "fortress balance sheet." Yet JPMorgan is still leveraged more than 25-to-1, based on its tangible equity. At a true fortress like Warren Buffett's Berkshire Hathaway (BRK-A), the leverage is just 3-to-1.

McDonald's colleague at Bernstein, Kevin St. Pierre, favors Comerica and U.S. Bancorp among the regionals. Comerica is now headquartered in Dallas and has significant exposure to depressed Michigan, but it also has one of the industry's highest capital ratios, based on common equity. U.S. Bancorp historically has had some of the sector's highest returns and should be in the black this year, too.

Investors didn't react well to Citigroup's announcement Friday that the government would convert up to $25 billion of its current preferred-stock investment under the Troubled Asset Relief Program into Citi common shares, giving Uncle Sam a 36% stake in the beleaguered bank. That action, combined with Citi's offer Friday to exchange some $27.5 billion of private and publicly held preferred into common shares, sent Citi shares down 96 cents, or 39%, to $1.50 on enormous volume: nearly two billion shares.

Investors are worried about several issues, including dilution, corporate governance and future business mix. If all the preferred is converted into common, Citi's share count will balloon to 22 billion from about 5.5 billion, massively diluting the positions of existing common holders, who will own just 26% of Citi shares.

The bull case on Citi now is that it has dealt with its capital shortfall and that the stock is appealing, trading well below the likely new tangible book value of $3.70 a share. "Investors are asking: 'Is Citi investable?' " says Bernstein's McDonald.

One concern among investors is that more than half of Citi's prospective common equity of $81 billion will consist of a deferred tax asset of $44 billion, which would protect some future earnings from taxes. The worry is that a wounded Citi may not be able to earn enough to use that shield.

Citi's $15 billion of preferred shares rallied on the news, although they are trading way below their face value. The company's Series P preferred finished Friday at $8.05, up $2.57 on the session, but still a fraction of the face value of $25.

Citi's preferred exchange offer created considerable confusion among investors because important details weren't released Friday. Citi is offering to swap common shares for preferred stock held by the public, but the precise exchange ratio probably won't be known until this week. Citi's publicly held preferred could rally if the terms are as generous as those accepted by the government and private investors, who are converting into common at about 45 cents on the dollar. In contrast, the publicly held preferred, trading at $8, is now valued at just 33 cents on the dollar.

Preferred holders probably should convert because Citi will stop paying dividends on unconverted preferred. Citi will continue to pay dividends on some $23 billion of outstanding trust preferreds.

If Citi's public preferred holders fare worse than the government, expect investor complaints. Congressional critics of TARP, too, could be upset at the Treasury's initial 55% loss on the conversion.