Banks have a capital problem

Banks may increasingly have to raise cash by issuing stock, a proposition which could bode poorly for current shareholders.

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NEW YORK (CNNMoney.com) -- So far, banks have had little problem raising capital to meet their growing need for more cash.

Major financial institutions worldwide including Wachovia (WB, Fortune 500), Washington Mutual (WM, Fortune 500) and National City (NCC, Fortune 500) have raised a staggering $213 billion since last summer, according to UBS, to help cushion the blow of the housing market downturn and weakness in the broader economy.

And it looks like banks will have to raise a whole lot more money. Facing what could be its first quarterly loss since going public later this month, Lehman Brothers (LEH, Fortune 500) is considering raising as much as $4 billion through a stock sale, the Wall Street Journal reported Tuesday. That news sent Lehman shares tumbling in Thursday trade.

But these current efforts mask how increasingly difficult capital raising is becoming. Banks not only have to balance the demands of regulators and shareholders but must take care not to employ a strategy that could prove fatal.

What has driven this appetite for cash, in part, is pressure from federal regulators. Agencies like the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency have ordered banks to beef up their capital levels to help cushion any losses going forward.

The proposition, however, isn't cheap. All that extra capital sitting on their books means banks have less money to invest and grow their business.

"Banks want enough capital to survive any storm but they don't want to raise too much or they are not competitive," said Adriaan Van Der Knaap, a managing director at UBS' financial institutions group. "It costs you to raise capital."

So far, banks have largely relied on the cheapest options available to raise money, employing hybrid securities like preferred shares or trust preferred securities.

But that option may quickly be running out. Rating agency Standard & Poor's warned Monday in its sweeping downgrade of several major financial firms such as Lehman Brothers and Morgan Stanley (MS, Fortune 500), that many banks have exceeded the rating agency's limit for hybrid securities.

As a result, banks are likely to have to issue more common stock. Some firms have already resorted to this option including the financial services firm State Street (STT, Fortune 500), which announced late Monday it would raise $2.5 billion through a stock offering.

But banks are generally reluctant to pursue such a strategy. For starters, it's a more expensive way to raise cash. Plus, the banks risk the wrath of existing shareholders since stock sales wind up diluting the value of their holdings.

In a sign of just how painful raising capital through common stock can be, former Wachovia CEO Ken Thompson went so far as to apologize to shareholders after announcing the bank's plan to raise $7 billion through a stock sale and a cut in the company's dividend in April.

"I know these actions are not without costs," Thompson said at the time. "I wish they were not necessary, but they are."

To be sure, banks have a variety of other capital raising options.

The mighty sovereign wealth funds, many of which generate their wealth from sky-high oil prices, control somewhere between $2 and $3 trillion in investable capital. And private equity firms still have plenty of cash to put to work, despite tough lending conditions.

But banks are usually at the mercy of their lenders when agreeing to such deals.

When National City (NCC, Fortune 500) announced its stock sale to a group of outside investors led by the New York-based private equity firm Corsair Capital in exchange for a $7 billion cash infusion in late April, it was at a 40% discount to the prior day's closing price.

Under the terms of its similar $7 billion deal with the private equity giant TPG, Washington Mutual (WM, Fortune 500) agreed to sell its stock at a 33% discount.

Borrowing from private equity firms can also be quite risky, warns Peter Sorrentino, a vice president and senior portfolio manager at Huntington Asset Advisors.

Typically, buyout firms have a short investment horizon. If they fail to see the company turn things around, they could push the bank to merge or sell.

"Once they have entered into the fold, the clock is ticking," he said. "They are going to get you to either get the share price up so they can cash out or they will marry you off."

As it stands right now, banks are expected to seek out another $120 billion in capital in the coming months, according to UBS.

But with soaring commodity prices, rising unemployment and ongoing woes in the housing market, it is very possible banks may need even more than that.

If the economy enters a protracted recession, they will once again have to make the rounds with hat in hand. However, it may be much tougher to raise capital. Investors may no longer be willing to place bets on banks if there is a growing sense that there is another shoe to drop in the credit crunch.

While banks may be quite far from that environment, such a scenario could prove ugly, experts warn. And that could mean more fire-sale mergers like JP Morgan Chase's takeover of Bear Stearns. Some companies may not even be fortunate enough to be acquired before going under.

"It would be very quick and very brutal," said Sorrentino.