Banking On the Comeback

Created by EQUITIES Magazine

The U.S. financial sector has been the hottest area for investors recently. How long will that last?

It’s been nearly two years since the robust financial system of the United States started showing cracks. Since then, investors have witnessed a global economic collapse of epic proportions. While the U.S. financial sector has been the most watched and the least embraced among most investors, savvy buyers have patiently waited on the sidelines for the perfect opportunity to capitalize. The excessive negativity targeted at financial stocks helped to push valuations out of whack. And unless the entire system was going to collapse—which the U.S. Treasury and the Federal Reserve System weren’t going to let happen—the pendulum was due to swing back, even if only for a temporary time span.

Since hitting its March 2009 lows, investors would be hard-pressed to find a grouping of stocks on as hot a streak as the financial sector, which just about doubled over the last three months. In May, the highly publicized bank “stress test” unveiled the current health of 19 of the United States’ largest financial institutions. The test was intended to help identify which institutions are at the greatest risk of failing. At the very least, it provided the market, and general public, with some transparency into the names that were fairly or unfairly dragged through the mud.

The stress test seemed to be the catalyst that the market needed to rally around the financial sector. Once the results were revealed, stocks took off. It didn’t seem to matter that more than half the banks tested needed to raise additional capital to withstand potential losses. Ten of the 19 banks needed about $75 billion in additional capital. Bank of America Corp. (NYSE: BAC) led the way by a large margin, needing almost $34 billion in additional capital. Wells Fargo & Co. (NYSE: WFC) needed $13.7 billion in new capital, GMAC LLC (NYSE: GJM) needed $11.5 billion, Citigroup Inc. (NYSE: C) needed $5.5 billion, and Morgan Stanley (NYSE: MS) needed nearly $2 billion.

That didn’t stop investors from rushing in, though. In the next month, shares of Bank of America soared 58%, Wells Fargo went up 27%, GMAC shares jumped more than 36%, Citigroup popped for an 18.6% gain, and Morgan Stanley shares grew more than 28%.

In order to raise capital to meet the stress test’s goals, banks have turned to slashing their dividends, selling its common stock, and other methods. Bank of America, for example, said it planned to raise capital through issuing common stock of up to $17 billion, private investors, and selling assets such as when it sold about $7.3 billion worth of shares in China Construction Bank in May. The company said in June that it was close to achieving its goal, having already raised $33 billion.

Not every bank needed to raise capital, however. Among those deemed healthy enough to sustain potential losses if the economy worsened included Goldman Sachs Group Inc. (NYSE: GS), JPMorgan Chase & Co. (NYSE: JPM), U.S. Bancorp. (NYSE: USB), BB&T Corp. (NYSE: BBT), and The Bank of New York Mellon Corp. (NYSE: BK).

Shares of these “healthy” banks did not perform as impressively over the same month but still produced decent returns for investors over that time. This is most likely because the market did not punish these banks as severely, hence shares did not need to recover as drastically. During the month after results were unveiled, shares of Goldman Sachs went up almost 20%, JPMorgan shares only went up 9%, U.S. Bancorp stayed virtually flat, BB&T shares were also flat, and Bank of New York shares rose 13%.

Several banks have even started to repay money borrowed from the U.S. Treasury’s Troubled Asset Relief Program. In June, the Treasury gave permission for 10 large financial institutions to repay $68 billion of the borrowed money, which would also free them from the government restrictions that came as part of the program. In fact, several banks were forced to take part in the $700 billion program.

Among those that repaid were U.S. Bancorp, which returned $6.6 billion; JPMorgan, which gave back $25 billion; Goldman Sachs, which repurchased roughly $10 billion worth of preferred shares from the government; and Morgan Stanley, which repaid $10 billion.

BB&T also said it would repay $3.1 billion and a final dividend payment to exit the TARP. Several other bank executives, including those from Wells Fargo and Bank of America, have said they plan to repay TARP money, as well.

Yet, even though there seems to have been significant progress made toward recovery in the U.S. financial system, skeptics continue to point at other looming concerns. Credit card companies, commercial real estate defaults, rising unemployment, and continued softness in the housing market are just some of the possible spoilers for a historic comeback story.

However, the Treasury has shown that it is willing to back major financial institutions, even if it means digging deeper to provide additional capital. On top of that, the Congressional Oversight Panel has expressed the need for more stress tests as these looming concerns continue to challenge the integrity of the U.S. financial infrastructure.

While it’s nearly inevitable that prices will come back down, the fear of a complete collapse—a la Bear Stearns, Lehman Bros., and Washington Mutual— seems to have subsided. Investors have rekindled their appetite for risk, albeit still at cautiously lower levels. In addition, there is growing concern that new regulations have become almost too tight for banks to operate effectively.

President Barack Obama blamed the lack of proper oversight and wild risk taking as the cause for the turmoil of the global economy. To address those issues, Obama unveiled a plan that would give far more authority to the Fed and Federal Deposit Insurance Corp. in governing banks. Now the possibility of going too far to the other side of the spectrum has many worried.

As the new landscape of the U.S. financial infrastructure continues to be laid out, the small back-and-forth compromises will have gigantic ramifications down the road. That’s why, for better or worse, all eyes are still on the banks.

By Henry Truc