Avoid This Stress Test

05/11/2009 11:15 am EST

Focus: MARKETS

Terry Savage

Author, The Savage Truth on Money

The stock market heaved a sigh of relief last week: The nation’s largest banks need “only” another $75 billion. Who knew they were in such good shape?

They rushed right to market to sell new stock, raise new capital. And investors lapped it up. The KBW bank index surged 12%. Bank of America’s (NYSE: BAC) stock jumped nearly 5% Friday as it announced plans to sell an additional 1.25 million shares, even as it questioned the government’s projections of its future income as overly cautious.

Wells Fargo (NYSE: WFC) priced a stock offering of $7.5 billion. Citigroup (NYSE: C) said it would “convert” some of the government’s preferred shares to common stock, thus raising over $5 billion. And Morgan Stanley (NYSE: MS) said it would raise cash through a sale of stock and bonds.

But before you rush to jump on the bank stock bandwagon, ask yourself a few questions.

1. What happened to the previous investors in bank stocks? The share prices went down—in some cases to zero. (OK, Lehman Brothers technically wasn’t a bank, but the partner “investors” lost everything.)  Remember all those “sovereign investment funds” and Saudi princes that jumped in to buy bank stocks last fall? And they were the “smart money!”

2. What’s different on the books of the banks? Yes, they still have lots of bad paper. A few changes in the “mark to market’ rule plus a clever maneuver that lets them count below-par bank debt as a current profit (because they could buy it back at the lower market price) have helped them report profits. 

But what else is new with their assets? Are borrowers suddenly more likely to repay loans on homes worth less than the mortgage? Are the unemployed more likely to keep up with their credit card payments?

3.  If you didn’t like the previous management, why buy stock in what is essentially a “government managed” industry (no matter how they camouflage it)? If Washington can fire the chairman of General Motors (NYSE: GM), how safe is any bank executive?  Who’s really calling the shots?  How many new loans will they command banks to make to troubled homeowners and businesses that are unlikely to repay?

4.  Who’s making the rules for the new banking game? (Just think how angry the government got when hedge funds with debt backed by assets wouldn’t roll over in the Chrysler bankruptcy and give up equity to the unions.) The administration has already tried to rewrite the rules of capital structure. What happens when foreclosures rise? Will they give homeowners some dividend-paying stock to help with their monthly mortgage payments? 

Yes, they’re doing every thing possible to stack the deck so banks can make profits. The Federal Reserve is doling out some of Alan Greenspan’s medicine from the early 1990s: keep short-term rates low and let the banks earn profits on the big spread on mortgages, commercial loans, and credit card debt. 

When you invest in bank stocks, you’re essentially betting those interest-rate-spread profits will beat future write-offs. But there’s an old rule: Never fight the Fed. So, bank stocks may be good for a bounce, and they’ve had quite a run already. But over the long run, not much has changed on the asset side.

So before you load up on these new offerings to buy “bargain” bargain bank stocks, remember this: You’ve already invested in the banks—through billions in TARP loans made with taxpayer dollars (or those yet to be printed). Why be even more exposed?

What do you think? Please join the conversation by making a comment now.

Related Articles on MARKETS