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Are Banks Returning TARP Funds Good Investments

written by: Brian Nelson•edited by: Rebecca Scudder•updated: 6/26/2009

The US banking industry seemed on the verge of collapse just a few months ago. Now, some of the big banks that took billions of dollars in TARP funds from the Treasury want to pay them back. Is that a good sign? Are those bank stocks good investments now?

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    Banks a Good Investment Now?

    Several US banks including JP Morgan, Goldman Sachs, Morgan Stanley, US Bancorp, Capital One Financial, Mellon Bank, and BB&T. The question on everyone’s mind is, “Are the banks paying back the US Treasury good investments right now?”

    The answer lies in how and why each bank is repaying the federal bailout funds they received late last year and early this year.

    For some banks, repaying the money lent by the US Treasury is a way to get rid of funds and restrictions that they felt they never really needed in the first place. For others, the need for the government bailout money is no longer there. Still others are repaying the government solely to get out from certain restrictions like those on executive compensation. Worst of all are those banks repaying the government in hopes of looking like they are just as healthy and well run as the other banks repaying their government loans.

    Determining which category a potential bank stock investment falls in to is the key to successfully investing in US Banks repaying their bailout money and reaping the profitable rewards that come with buying low in the US Markets before others return to investing in the financial sector. However, getting it wrong could lead to dramatic losses or being wiped out completely because repaying the TARP or CAP loans before actually ready could leave the bank in an even weaker position than it was before. Banks that were bailed out once before are unlikely to receive sympathetic ears to be bailed out a second time, especially if other banks demonstrate that they are functioning just fine without any more government help.

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    Determine Which Bank Stocks Are Good Investments

    How to categorize a bank stock that is repaying the US Treasury?

    First, consider how much capital the bank had to raise under the government stress test run on banks earlier this year. Those that had to come up with large amounts of money and are still paying back the government are likely to be the weakest banks. Diluting shareholder capital or engaging in large borrowing efforts are likely to cripple the bank’s stock price for years to come. Those banks that reached deeper than they had to just to be able to repay a loan that no one was calling for repayment on will be in trouble faster. Even if those banks manage to succeed, such a strategy demonstrates an executive management that is still taking too much risk in an effort to get ahead.

    Also, keep in mind that any company widely reported as on the brink of failure without government aid probably is not that much better off than it was just six months ago. These banks should NOT be repaying the government money and are definitely NOT good investments.

    For banks that did not need to raise any capital because of the government’s banking system stress test and who were also able to repay the government loans without raising additional capital in the markets are the strongest companies. These companies were able to repay their loans without having to harm their shareholders. Additionally, since they took on no new debt, their balance sheets should be no worse for the wear for having repaid the government loans.

    Unfortunately, knowing exactly where each bank falls is a difficult task made more difficult by the recent change to accounting rules that allow companies to value the same toxic assets that caused them so many problems just a few months ago at higher values. Without disclosing exactly how much of a difference such a change made, investors are stuck not knowing if a bank is really healthier or just healthier on paper.

    So far, it seems that the safer plays are banks like JP Morgan Chase and Mellon Bank that seemed to be in trouble only for a short period of time. However, even investing in JPM or BK could be very risky if the economy takes another turn for the worse instead of progressing along in its recovery.

    Investing in major bank stocks should be considered part of the risky and volatile part of your portfolio right now. Adjust the rest of your stock portfolio to be more conservative to account for the extra risk.