Investors seek clarity from stress test results

The U.S. government was preparing on Thursday to draw a line separating the weak from the strong in the banking sector in an attempt to put the worst of the financial crisis behind it.

The results of stress tests of the 19 largest U.S. banks

-- due at 5 p.m. EDT (2100 GMT) -- are the culmination of a months-long exercise aimed at reviving the financial system and are expected to show about half the banks need more capital.

The government is focused on banks filling shortfalls in their equity capital -- an amount that Goldman Sachs analysts estimated could total $130 billion this year.

That estimate included what the stronger institutions would need to raise to pay back government money and funds the weaker ones need to fill shortfalls.

Bank shares broadly have climbed about 50 percent since the stress tests were first announced as part of a wider plan to revive the sector in February. But on Thursday, the KBW Banks Index slumped 3.4 percent, and some investors viewed the stress test results as spelling an end to that rally.

From my perch, investors should sober up and reduce their holdings in financials now, hedge fund manager Doug Kass said in a note to clients. Financial stocks are now priced to perfection.

In an interview, Kass said he was selectively selling short some bank stocks.

Federal Reserve Chairman Ben Bernanke described the tests as a fair and comprehensive effort that he hoped would allow markets to have greater confidence that they know the condition of the banks. [ID:nL71021272]

(Markets) can be reassured that banks will be strong and be able to lend even if the economy is worse than currently expected, he said.

U.S. Treasury Secretary Timothy Geithner, who along with other top regulators will brief the media on the stress test results, said in an opinion piece in The New York Times that the tests applied exacting loss estimates and conservative earnings estimates, an apparent rebuff to critics who have questioned whether the tests were tough enough.

U.S. President Barack Obama's team appears to have managed market expectations well, getting the worst news from the stress tests out two days ago -- that Bank of America needs as much as $34 billion in common equity capital.

It looks like a pretty well choreographed dissemination of information, said Craig Peckham, equity trading strategist at Jefferies & Co in New York, adding that Washington has managed to mitigate the impact that surprise results might have on stock markets.

CREDIBILITY CONCERNS

But skeptics of the administration's bank strategy still abound.

The American Bankers Association criticized the severity of the stress tests and said there was no evidence banks need to change the make-up of their capital. But it said the test results should end harmful speculation.

Some analysts and investors questioned the credibility of the tests.

At best, the process may have been a waste of time; at worst, it's something that has caused more confusion, said Mike Holland, chairman of private investment firm Holland & Co. It is not clear, for example, precisely how banks will have to increase equity capital, he said.

Among banks needing equity capital, Bank of America Corp shares closed up 6.46 percent at $13.51 on the New York Stock Exchange, while Wells Fargo & Co fell 7.75 percent to $24.76.

Wells Fargo announced a $6 billion stock offering after the market closed, sending its shares down a further 1.5 percent in after-hours trading.

The stress tests are expected to show the San Francisco-based bank needs to fill a $15 billion capital shortfall.

Shares of JPMorgan and Goldman Sachs, which are not expected to need to raise common equity, fell 5.32 percent to $35.24 and 4.02 percent to $133.73 respectively.

Among other stress tested institutions, the government will also tell institutional money manager State Street Corp that it does not need to raise new capital, a person familiar with the results said. State Street shares closed down 3.32 percent at $37.83.

COVERING SHORTFALLS

Banks may cover any capital shortfalls through a mixture of asset sales, share sales and perhaps the conversion of preferred shares into common stock.

If a bank raises common equity by converting preferred shares issued under TARP, the government could become one of the bank's biggest shareholders.

The government is giving banks needing capital one month to develop a plan to raise it, and until November 9 to finish the job.

The banks must also review their management and boards of directors to ensure proper leadership. The White House said it will await stress test results before commenting on banks' potential management changes.

Banks like Goldman and JPMorgan, which have said they want to repay TARP funds received last fall, cannot return the aid until they issue debt not backed by the federal government, and for more than a five-year term.

Analysts believe other banks that may need capital include Fifth Third Bancorp, KeyCorp, PNC Financial Services Group Inc and SunTrust Banks Inc.

(Additional reporting by Jonathan Stempel, Paritosh Bansal, Ellis Mnyandu, Dan Wilchins, Jennifer Ablan and Ryan Vlastelica in NEW YORK; Karey Wutkowski, Mark Felsenthal, David Lawder, Glenn Somerville and Jeff Mason in WASHINGTON; Douwe Miedema in LONDON; and Michael Flaherty and Parvathy Ullatil in HONG KONG; Editing by John Wallace, Bernard Orr and Ted Ker)