What's next for banks? Nobody knows

Confusion about the bank stress tests is causing massive volatility in the market. It will be bad news if the tests don't name winners and losers.

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

Which money-losing Fortune 500 company is most likely to turn a profit this year?
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Shares of credit card lender Capital One Financial have been on a wild ride for the past two days. Other bank stocks are suffering from motion sickness as well.

NEW YORK (CNNMoney.com) -- Are banks in better shape now than they were before the government started injecting gobs of capital into them?

Wall Street doesn't seem to have a clue. And that's kind of scary.

Regulators are preparing to soon release the results of stress tests that will determine whether 19 of the nation's largest financial institutions need to raise more funds.

Many bank stocks have more than doubled in the past six weeks on hopes that no bank will actually fail. And Treasury Secretary Tim Geithner is doing his best to try and assure jittery investors that the banking sector is not headed to H-E-double hockey sticks in the proverbial hand basket.

On Tuesday, for example, he said in front of a Congressional panel that the "vast majority" of banks are well-capitalized.

The problem is that every time Geithner opens his mouth to say that banks are going to be okay, he sparks a rally in the "vast majority" of bank stocks. And that rally may not be warranted.

Take a look at what happened Tuesday with credit card lender and regional bank Capital One Financial (COF, Fortune 500). Shares of the bank, which was due to report first-quarter results after the closing bell Tuesday, fell about 6% at the open.

But traders started to digest Geithner's comments, Capital One shares soared with the rest of the banking sector. They finished the day up 12.5%.

So it seems investors were suddenly of the opinion that Capital One, like many of its banking peers, would report better than expected results.

Nope. Capital One bucked the trend, posting a 45 cent per share loss. Analysts were forecasting an 8 cent loss.

One would think that's bad news. Still, investors couldn't seem to figure out what to make of it.

In just the first half hour of trading Wednesday, Capital One's stock fell as much as 10% but then roared back and was up as much as 8%. What's in your wallet? It depended on what time you looked at the stock price. The stock wound up finishing Wednesday down about 4.5%

"Trading has been pretty volatile even for these times," said Mike Taiano, an analyst with Sandler O'Neill & Partners. "Financials have never been more tied to what's going on in Washington right now."

Capital One is worth keeping an eye on since the company's banking unit had $166 billion in assets as of year-end 2008. So that makes it big enough to be one of the 19 companies undergoing the stress tests.

But Capital One isn't the only big bank that investors can't make up their minds on either.

Morgan Stanley (MS, Fortune 500) gained 5% Tuesday -- after being down as much as 4% earlier in the day -- in anticipation that it too would follow the lead of Goldman Sachs (GS, Fortune 500), JPMorgan Chase (JPM, Fortune 500), and even Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500) and report healthier than expected results.

That also didn't happen. Morgan Stanley reported a much wider than expected loss Wednesday morning and its stock fell 9% for the day.

Grading on a curve?

Prior to the onslaught of quarterly results, investors seemed to be suffering from the illusion that all banks would be deemed fiscally fit by Treasury, the Federal Reserve and the FDIC.

But while the government will probably be careful to avoid making it look like the banking sector's weakest links are in imminent danger, it's growing readily apparent from the quarterly results from big banks that some deserve a gold star and others should be sent to the corner with a dunce cap.

"There a lot of mixed signals coming out on stress tests and people are anxious to see how the banks will do. But in order for it to look like it's a fair assessment of risk, there has to be some winners and losers," Taiano said.

Along those lines, U.S. Bancorp (USB, Fortune 500), a regional bank based in Minneapolis, reported stronger than expected earnings on Tuesday. And like Wells and JPMorgan Chase, the bank has long been viewed as one that did a better job than others of managing risk during the past few years.

So it seems that investors probably don't have to worry too much about U.S. Bancorp flunking the stress test. And for that reason, it's not as much of a headscratcher that shares of U.S. Bancorp shot up 25% after reporting its results Tuesday.

Frank Barkocy, director of research Mendon Capital Advisors, a money manager that invests primarily in bank stocks and owns shares of U.S. Bancorp, JPMorgan Chase and regional bank PNC (PNC, Fortune 500), said some banks deserve to be bouncing back after being pummeled in the wake of last fall's Lehman Brothers collapse.

"We're not jumping up and down and pounding the table about banks, but at the same time this doesn't mean you shouldn't own some bank stocks," Barkocy said. "There are signs to give you encouragement that some banks are in good shape."

But other regional banks, particularly those in some of the hardest hit areas of the country during this recession, namely the Midwest and Southeast, are probably not going to fare as well during the stress tests.

Two Ohio-based banks, Cleveland's KeyCorp (KEY, Fortune 500) and Huntington Bancshares (HBAN) of Columbus, both reported losses in the first quarter.

Regions Financial (RF, Fortune 500), a Birmingham, Ala.-based bank, did manage to post a small profit. Investors were expecting a loss. But the bank barely broke even when you factor in preferred dividend payments to the government. Key, Huntington and Regions are all big enough to be subject to the stress test.

Two other hard-hit regional banks taking part in the stress test, Cincinnati's Fifth Third Bancorp (FITB, Fortune 500) and Atlanta-based SunTrust (STI, Fortune 500), are due to report first quarter results Thursday morning. Analysts are expecting both banks to post a loss.

So if regulators give their blessing to all 19 banks, the Treasury Department risks looking foolish. Hopefully, that won't happen and the stress tests will put an end to all the speculation and allow investors to clearly identify the stronger and weaker banks.

Jaret Seiberg, a policy analyst with Concept Capital's Washington Research Group, pointed out in a report Wednesday that between four and eight banks are likely to need new capital as a result of the stress tests.

"Treasury needs this test to be credible. If everyone passes, no one will believe the results. But the headline risk to the economy could be extreme if everyone fails. So we believe the government wants a middle ground," he wrote.

Want a Money Makeover? E-mail us at makeover@moneymail.com. For the CNNMoney.com Comment Policy, click here.  To top of page

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