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5 Banks Hinging on Fed Stress Tests

Out of the 19 large U.S. bank holding companies undergoing Federal Reserve stress tests, five stand out as having the most at stake, although not for the same reasons.

All of the financial holding companies undergoing the stress tests received government bailout money through the Troubled Assets Relief Program, or TARP, except for MetLife . For some, the stress tests will open the door for dividend increases and possible share buybacks, which will cheer investors. For others, the stress test results will determine the size of dilutive capital raises needed to repay TARP.

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Citigroup received a total of $49 billion in TARP money—the most for any bank. In July 2009, $25 billion in preferred shares held by the government were converted to common shares. Through the sale of these common shares and warrants, the Treasury reported a profit of about $6.9 billion through the end of 2010. Citigroup repaid its remaining TARP money in December 2009.

Bank of America received a total of $45 billion in TARP money and exited the program in December 2009. The company stands out among the group of 19 financial holding companies undergoing the stress tests, as the only one to post a net loss for the fourth quarter.

The four companies among the group of 19 that still owe TARP money are Ally Financial, SunTrust , Regions Financial and KeyCorp . These four have much riding on stress test results, including the amount of capital they will need to raise in order to remove government training wheels.

While we don't know if the Federal Reserve will publicize its stress test results, investors are expecting most of the banks that have exited TARP to announce dividend increases soon after the tests are completed. For Bank of America, the mortgage overhang and lower level of capital will mean that investors will be waiting considerably longer for a dividend increase than investors of other large players, including Citigroup and JPMorgan Chase .

The following is a quick look at Bank of America and the four remaining TARP banks among the Stress Test group of 19:

5. Bank of America

Shares of Bank of America closed at $14.84 Wednesday, down 2% from a year earlier. This is by far the worst performance among any of publicly traded companies listed here, despite the fact that the Bank of America doesn't face the obvious need for additional capital to repay TARP.

Bank of America reported a fourth-quarter net loss of $1.2 billion, which included a multitude of extraordinary items, including a non-cash goodwill charge of $2 billion, and more importantly, $4.1 billion in provisions for "outstanding and future mortgage claims." These provisions included $3 billion for potential and future claims by Fannie Mae Freddie Mac for Countrywide mortgages sold to the government sponsored enterprises through 2008.

Bank of America had a Tier 1 common equity ratio of 8.60% as of December 31, and was well-capitalized per regulatory standards, but Richard Staite of Atlantic Equities said in a report after the company's fourth-quarter earnings release that although the company did "not disclose the ratio under Basel III," his firm believes "it is weaker than peers and that a dividend increase is "some way off."

Staite also said that despite the company's major fourth-quarter effort to address its legacy mortgage risk, "investors may remain concerned over the private label litigation threat."

Despite the mortgage overhang, 16 of the 25 analysts covering Bank of America rate the shares a buy and there are no analysts recommending investors sell the shares. The mean price target among analysts polled by Thomson Reuters is $18.21, which would be a 23% gain from Wednesday's close. The shares trade for a shade under 8 times the consensus earnings estimate of $1.86 a share for 2012. This is the lowest forward P/E among the 18 publicly traded financial companies subject to the stress tests.

Bank of America's shares are at bargain levels to forward earnings, and on that basis appear to be a steal for long-term investors. The obvious question is whether or not there is a major surprise ahead on the mortgage front.

Looking at the fourth-quarter hedge fund filings that were made public this week, opinion on Bank of America is mixed. Warren Buffet's Berkshire Hathaway sold its entire stake in the company in the fourth quarter, while John Paulson's investment fund trimmed its position. Buyers of Bank of America during the fourth quarter included Fairholme Capital Management, which increased its stake by 30% to 21.5 million shares. Appaloosa Management and George Soros's fund management partnership also added to their holdings.

Further discounting of the shares could be just around the corner, with additional headline risk from congressional scrutiny of Countrywide's lending practices and possible fines from bank regulators over foreclosure practices. Reuters reported on Wednesday that David Stevens, the commissioner of the Federal Housing Finance Agency had prepared testimony saying that mortgage servicers could face fines and other penalties, including forced loan modifications.

Click to Read About the Other 4...

4. Ally Financial

Ally Financial is the former General Motors Acceptance Corporation , which was a unit of General Motors until 2006, when GM sold a 51% stake to Cerberus Capital Management.

GMAC was rebranded Ally Financial last year. The company received a total of $16.3 billion in TARP money, and all but $5.9 billion of the government's preferred shares in the company have been converted to common shares. According to the Treasury's most recent TARP Transactions Report, government holds 74% of the company's outstanding common shares.

Ally Financial is preparing for a public offering to take place at some point after the stress tests are completed. The Treasury announced in January that it had selected Perella Weinberg Partners was selected as advisor for the coming IPO. Bloomberg recently reported that Ally had selected Citigroup, Goldman Sachs and JPMorgan Chase as underwriters for an offering which could take place as early as May, citing sources.

Ally reported net income of $79 million for the fourth quarter, compared to a net loss of $5 billion in the fourth quarter of 2009. The company's provision for loan losses declined to $71 million from $3.1 billion a year earlier, and the fourth-quarter 2009 results also included $1.7 billion in losses from discontinued operations. For all of 2010, net income was $1.08 billion, compared to a net loss of $10.3 billion in 2009.

Unlike the old GMAC, the company is relying more and more on deposits gathered through Ally Bank and ResMor Trust to fund its lending. Deposits provided 29% of total funding as of December 31, and retail deposits increased 29% over the previous year.

Ally says it is the fifth-largest mortgage servicer in the U.S., and pre-tax income from its mortgage operations totaled $123 million during the fourth quarter.

On February 7, Moody's upgraded its senior unsecured rating for Ally Financial to B1 from B3, with a stable outlook, citing reduced exposure to problem loans and mortgage repurchase risk.

SNL Financial said in a report on Monday that the IPO market for specialty lenders was heating up, and that Ally stood out with a diverse array of services, which in addition to auto and mortgage financing and servicing, include dealer floor plan servicing and insurance. SNL also pointed out that "the U.S. Treasury has an interest, quite literally, in Ally's attempts to monetize the business."

3. KeyCorp

Shares of KeyCorp closed at $9.55 Wednesday, returning 39% over the previous year.

Out of the three publicly traded bank holding companies that still owe TARP money, KeyCorp's December 31 Tier 1 common capital ratio was by far the highest, at 9.31% according to SNL Financial. Earlier this month, This exceeds the magic number of 9% cited by Brian Foran of Nomura Securities as "the main metric to repay TARP," although most analysts still expect a relatively modest capital raise for KeyCorp as it prepares to repay the government following the stress tests.

During the company's conference call following its fourth-quarter earnings announcement, CEO Henry Meyer said when discussing the Tier 1 common ratio that "we look at where others are and think that there is going to be an opportunity to be more shareholder-friendly, less dilutive."

KeyCorp's management has done an excellent job over the past year, improving the company's operating performance across the board, while reducing expenses.

The company's fourth-quarter net income attributable to common shareholders was $279 million, compared to a loss of $265 in the fourth quarter of 2009.

Noninterest income was up 27% year-over-year to $492 million, with major improvements in investment banking and mortgage loan production and sales. Meanwhile, noninterest expenses declined 15% from a year earlier to $744 million, with the bulk of the savings in personnel costs, which were down 10% to $365 million, as expenses for employee benefits were reduced.

The shares trade for 13 times the consensus 2012 earnings estimate of 76 cents a share. While that's not a prohibitively high forward P/E for a bank with improving fundamentals, it's high for a TARP back in the current environment.

Most analysts consider the shares fully valued. Two out of 24 analysts rate the shares a buy, while 19 have neutral ratings and three recommend selling the shares.

Jeff Davis of Guggenheim bucks the trend with a buy rating and $11 price target for Key, saying after the earnings release that the company was "borderline over-capitalized," and that it would be able to repay TARP with a "minimal common issue," with positives including "leverage to the industrial Midwest economy and less exposure to the consumer."

2. Regions Financial

Shares of Regions Financial closed at $7.76 Wednesday, returning 18% over the previous year.

There's a lot of buzz about Regions being a takeout target, and Bruce Berkowitz of Fairholme Capital Management suggested recently that a pairing with CIT Group would make sense.

Regions reported fourth-quarter net income available to common shareholders of $36 million, compared to a net loss of $606 million a year earlier, as credit costs declined. Unlike KeyCorp, Regions didn't release reserves during the fourth quarter, as its provision for loan loss reserves of $682 million matched its net loan charge-offs.

The company's Tier 1 common equity ratio was 7.90% as of December 31, indicating a major common equity raise will be required to repay TARP. After Regions announced its fourth quarter results, Christopher Mutascio of Stifel Nicolaus said the company remained "a laggard in terms of credit," and would "likely be the last of our large cap banks to exit TARP." Mutascio estimated that the company would need to raise $1.75 billion in common equity to repay the government.

Mutascio told The Street earlier this week that Regions could be worth $9 a share to an acquirer, but Richard Bove of Rochdale Securities has the opposite opinion that the stock would have to be heavily discounted to "$5 to $6 per share" to be attractive to an acquirer.

Bove on Wednesday downgraded Regions to "Sell" from a neutral rating, saying that the recent rise in the share price was due in part to "a belief that Regions has failed the most recent stress test and that the bank will be required to sell." He said that "despite the fact that the new management team is engineering a successful turnaround, this stock appears to be overvalued."

Only one of the 22 analysts covering Regions rates the shares a buy, while 17 analysts recommend holding the shares and four now recommend selling.

1. SunTrust

Shares of SunTrust closed at $32.35 Wednesday, returning 43% over the previous year.

SunTrust is also being bandied-about as a takeout target, with an industry veteran telling TheStreet recently that although the company competes in many of the same markets as Regions, SunTrust has the more attractive branch locations.

SunTrust's credit costs are also declining faster, as it was able to release $112 million in loan loss reserves during the fourth quarter. Net income to common shareholders for the fourth quarter was $114 million, compared to a net loss of $316 million in the fourth quarter of 2009.

Analyst opinion varies widely, with eight out of 31 analysts rating SunTrust a buy, while 17 analysts have neutral ratings and six recommend selling the shares.

After the company announced its fourth-quarter results, Adam Barkstrom of Sterne Agee reiterated his sell rating, saying the shares were overvalued as speculation of a takeout had "artificially lifted the valuation and overlooked the limited insulation provided by the lower core earnings power and reserve coverage relative to peers."

Meanwhile, Christopher Marinac of FIG Partners maintained his "outperform" or buy rating, saying that SunTrust "remains poised to earn greater profits" and that even if the company were to raise $1 billion to repay TARP, "normalized EPS on the higher share count still a healthy range of $3.45 and $3.60," justifying a price target of $38.00.