Bank Stocks: The Trouble with TARP

Financial stocks plunged Jan. 20 as investors worry about the strings attached to the U.S. Treasury's bailout of institutions like Bank of America

By Ben Steverman

Just as the prospects for bank stocks can't seem to get any worse, they do.

To the all-too-real problems of the financial crisis and recession, add another serious concern: A U.S. government bailout may prop up the financial system and save big banks from collapse, but it may prove disastrous for bank shareholders.

A case in point is Bank of America (BAC), which led the stock market lower on Jan. 20 by plunging 29%.

With shares of Citigroup (C), another troubled banking giant, dropping 20%, financial stocks were responsible for much of the stock market rout on Jan. 20. The Dow Jones industrial average lost 332 points, or 4% of its value, while the broad Standard & Poor's 500-stock index, with a heavier concentration of financial stocks, lost 5.3%.

Investors were clearly worried about mounting problems for banks, exemplified in recent earnings reports that show huge increases in problem loans and billions more in investment losses.

Cure for a "Bankrupt System"?

New York University Professor Nouriel Roubini, who foresaw the credit crisis, heightened investors' panic when Bloomberg reported on Jan. 20 that he estimated credit losses for U.S. firms could hit $3.6 trillion. Thus, the U.S. banking system—with just $1.4 trillion in capital—is "effectively insolvent," Roubini said, according to Bloomberg. "The problems of Citi, Bank of America, and others suggest the system is bankrupt," he added.

The supposed cure for this is the federal government's $700 billion Troubled Assets Relief Program, or TARP, enacted late last year. However, a growing number of investors and analysts warn that the TARP program may come at a large cost to bank shareholders.

Banks get TARP relief only by giving the federal government preferred shares. On Jan. 16, BofA issued the government another $20 billion in preferred stock that pays an 8% dividend. In exchange, the government agreed to limit future losses on $118 billion in BofA investments, including a large amount of the portfolio acquired through BofA's buyout of Merrill Lynch.

"Increased support by the U.S. government provides protection on certain problem assets," notes Deutsche Bank (DB) analyst Mike Mayo, but "it also comes with more restrictions on [BofA] as a whole."

TARP Payments Jeopardize Dividends

There are three main concerns about the government's rising stake in banking firms like BofA, says Stifel Nicolaus (SF) analyst Christopher Mutascio.

First, there is the size of dividend payments due to the government each year, which leave little remaining for regular shareholders. On Jan. 16, BofA slashed its first-quarter dividend to just 1¢ per share. Meanwhile, Mutascio estimates the preferred dividend payment to the U.S. Treasury will be $4.8 billion per year. That's 73% of the total net income he expects from BofA in 2009.

FBR Capital Markets (FBR) analyst Paul Miller estimates preferred dividends could shave 90¢ per share off BofA's annual earnings "for the next three years at least."

Second, the TARP program's investments must eventually be paid back. At BofA, the government's equity stake is $49 billion. After the stock's disastrous drop on Jan. 20, the government's equity stake is almost twice the public market capitalization for the bank of $25.6 billion. To repay TARP money, Mutascio warns, banks may need to issue new public shares, which would greatly dilute current shareholders' stakes.