Bank stress tests: Everybody gets an A!

Even though a majority of the 19 banks that took part in the stress tests might be required to raise more capital, the market is giving them all a gold star. That's silly.

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By Paul R. La Monica, CNNMoney.com editor at large

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How strong are the nation's 19 largest financial institutions?
  • All the major ones are fine
  • Most of them are fine, with a couple of exceptions
  • There are widespread problems in the system
Photos
Bank stress test: How will the 19 do?
Regulators are expected to finally deliver the results of the stress tests for the nation's 19 largest banks on Thursday. Here's what you need to know.
banks0505.mkw.gif
The broader market's gains over the past two months pale in comparison to bank stocks. The KBW Bank Index, a key barometer of big banks, has more than doubled.

NEW YORK (CNNMoney.com) -- We'll have to wait until Thursday for the official results of the eagerly awaited stress tests on 19 of the nation's largest financial firms.

But amazingly, the more that gets leaked out, the more excited investors get.

Despite reports that anywhere between 10 and 14 of the banks could be forced by the government to raise capital, shares of all the stress-test participants surged Monday. (This does not include General Motors, a minority owner in auto lender GMAC.)

In fact, they didn't just rally -- they exploded. Morgan Stanley (MS, Fortune 500) gained 4.7% and it was the worst performer. Shares of a dozen stress-tested banks soared more than 10%.

Three regional banks widely believed to need more funding -- Birmingham, Ala.-based Regions Financial (RF, Fortune 500), Cincinnati's Fifth Third Bank (FITB, Fortune 500) and SunTrust Financial (STI, Fortune 500) of Atlanta -- each gained more than 25%

And Wells Fargo (WFC, Fortune 500), considered one of the strongest, also shot up nearly 25% -- despite reports that it too may need to raise more capital.

Monday's bank bacchanalia is just the latest in a heady rally for the group. On average, shares of the 18 publicly traded stress-tested banks are up nearly 130% since March 9.

The gains make some sense since some of the stocks were probably oversold earlier this year.

"Some investors were expecting stock prices of zero to be reality," said Mike O'Rourke, chief market strategist with BTIG, an institutional brokerage firm in New York.

Those fears appeared to be wildly overblown. But it's getting tougher to justify why these bank stocks should be trading much higher.

If the government forces Wells, Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500), for example, to raise more funds, there are two conceivable ways for that to happen. And neither is great news for existing shareholders.

Banks could sell more common stock to investors, which would dilute the value of stock owned by current shareholders.

Or the government could convert some of the preferred shares they own in these banks as a result of TARP into common shares. Once again, current shareholders would likely take a hit.

O'Rourke said that converting preferred shares to common stock could be viewed by investors as a lesser of two evils. That's because it would mean that the government, and hence taxpayers, would not have to commit new funds to bail out banks that need more capital. But it's still not great news.

"A lot of bank bears were waiting for the stress tests to be catalysts for stocks to go down," he said. "I am surprised that the rally has been this strong going into this uncertainty. If the stress test results are poor, current stakes could convert from preferred to common. That's still dilutive."

Worst may be over for some, but not all, banks

Another reason for the big bank stock rally could simply be the growing sense that the recession may soon be over. In other words, banks are being told they need to prepare for a worst-case economic scenario that fewer people believe will come to pass.

Still, it's a bit naive to think that banks are out of the woods.

"Essentially, you have a broken financial system. Something like this doesn't tend to get fixed in six months. The longer-term picture for banks is still questionable," said Rick Bensignor, chief market strategist with Execution LLC, a broker dealer in Greenwich, Ct.

In fact, some short sellers, investors who borrow a stock and sell it with the hopes of buying it back later at a lower price, have been increasing their bearish bets.

The level of short interest, the number of shares sold short but not yet repurchased, for several of the stress-tested banks is higher now than it was before the credit markets collapsed last fall.

Short interest in Bank of America as of mid-April, for example, is up nearly 50% since mid-September of last year. Short interest is also up sharply during the same time frame for Citigroup, KeyCorp, State Street (STT, Fortune 500) and American Express (AXP, Fortune 500).

But the increased short interest could also be fueling some of the big gains, particularly Monday's move, according to Bensignor. That's because the shorts do have to eventually buy back shares.

So when a stock is moving higher, shorts occasionally need to rush in and buy to minimize losses, a phenomenon known as a short squeeze. This could prove to be just a temporary phenomenon though.

This is not to say that all banks are doomed. One investor who is long several financial stocks argued that all the potential bad news about banks is now more than priced into the stocks. So even weak stress test results won't be enough to derail their momentum.

"It's been telegraphed over the past few weeks that banks still have a liquidity problem, but the government will not allow any of the large U.S. banks to fail," said Paul Britton, CEO of Capstone Holdings Group, a New York trading firm specializing in volatility investing.

"Even if a bank continues to struggle, there will be an AIG solution rather than a Lehman solution, namely a slow surgical procedure to save the company rather than letting it go under," Britton added.

But propping up AIG hasn't exactly worked out well for taxpayers or the company's shareholders. And investors are still refusing to separate winners and losers. Instead of bidding up every bank ahead of the stress test release, the more prudent thing to do is to wait for the results, analyze them and then identify those banks that appear to be in better shape than others.

Not all banks are weak. But not all banks are strong either. And the longer that Wall Street continues to stubbornly believe that the worst is over for all banks, the uglier things could be once investors belatedly realize that some banks are still in trouble.

"Euphoria tends to be something that doesn't last," said Bensignor. "People are just getting comfortable with the idea that banks are okay because the market has moved up. But there is a market and then there are underlying companies." To top of page

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