JPMorgan Chase & Co. and American Express Co. were told they need to boost common equity, less than four weeks after being informed they had enough to withstand a deeper economic slump. Morgan Stanley was directed to raise more funds after already selling stock to cover its stress-test shortfall. One firm was told June 1, people with direct knowledge said.

This means two things. 1) That the government’s stress tests were indeed a sham designed to coax investors back into bank stocks. 2) That the government expects more pain for the banking sector and isn’t prepared to have banks get out from under the TARP only to come back begging for federal aid at a later date.

As former New York Fed executive vice president pointed out recently, if banks repay TARP funds next week, “politically, the administration can claim a victory. They can claim TARP is working, we’re getting our money back and making a profit. But there are more shoes to drop in commercial and industrial loans, leveraged loans, and real estate.”

As we have attempted to make clear all along in Notes , this crisis boils down to a battle between hope versus facts. You know which side Team Obama and the mainstream press is on. And you know which side we’re on.

The latest Federal Reserve survey of senior loan officers finds very few shoots of green in that garden. According to the survey, “A significant majority of banks reported that credit quality for all types of loans is likely to deteriorate over the year.” And this assumes the economy won’t get any worse than it already is now! Here are some specifics (hat tip, Real Time Economics)

Commercial and industrial loans: Of 52 banks responding, none said they expect improving quality, but seven said they expect delinquencies and charge offs to stabilize at current levels.

Commercial real-estate loans: Only 1 of 51 banks (the other doesn’t make such loans) sees improving quality, and three see quality stabilizing at current levels. Of the 47 who see a worsening picture, 13 expected a substantial deterioration in 2009.

Prime residential mortgages: Only 1 of 50 banks sees improving quality, and seven see quality stabilizing at current levels.

Subprime mortgages: No bank sees improving quality, and only two see quality stabilizing at current levels.

Home equity lines: No bank sees improving quality, though nine expect quality to stabilize around current levels.

Credit card loans: None of the 31 banks who make such loans expects improvement, and three expect stabilization.

Other consumer loans: Only one of 50 banks expects improvement, though 12 see loan quality stabilizing around current levels.

The U.S. Federal Reserve’s actions in cutting short-term interest rates to almost zero – together with a gentle rise in U.S. Treasury bond yields since the start of the year – have given us a steeply sloping yield curve, where long-term rates are about 3% above short-term rates.

What’s more, lending rates to corporate and personal borrowers are way up, far more than Treasury bond rates. That means one thing: In their new lending – particularly to small businesses – banks are making money like gangbusters.

At least, some of the banks are…

Let me explain.

The “steeply sloping yield curve” is bond-market jargon for a situation where long-term bond rates are far above short-term money market rates. In this case, the Fed has forced money market rates down to nearly zero, but has had much less effect on long-term bond rates, which have shown a tendency to rise, both because of the escalating budget deficit and because of the possibility of recurrent inflation arising from the Fed’s rapid expansion of the money supply.

Since banks generally borrow short-term money – in the form of demand deposits and short-term time deposits – and generally lend medium-term and long-term money, in the form of industrial loans and leases, automobile loans and home mortgages, a steeply sloping yield curve makes the banking business exceptionally profitable. Borrowing short-term at 1% and lending on a prime home mortgage at 5.5% or 6%, often with a “government” guarantee from Fannie Mae (FNM) or Freddie Mac (FRE), is good business however you look at it, for as long as the steep yield curve lasts.

In addition, the premium that industrial borrowers pay above U.S. Treasury bond rates has sharply widened, so banks can make much more money on their commercial loan and lease business.

That doesn’t mean we should all rush out and buy shares in Citigroup Inc. (C). For one thing, Citigroup is involved in all sorts of investment banking, and in a variety of trading businesses, most of which are either down sharply due to the recession or that have disappeared altogether. For another, we still don’t know how large and how toxic are the assets on Citigroup’s balance sheet.

Whereas regional banks have been coping quite well with their impaired-value assets, Citigroup has been forced to get a $300 billion guarantee on its assets from the Fed, and nobody knows if even that will be enough. The bank is now controlled by the government, and may be nationalized entirely.

Even at their nadir of 97 cents last week, Citi’s shares are nothing less than a lottery ticket. That ticket would have paid off if you’d bought last week, with a gain of 130% in a week, but neither I nor anyone else can give you accurate odds on whether it will pay off in the weeks to come.

Of the big banks with assets of more than $1 trillion, only one is attractive. Apart from Citigroup, Bank of America Corp. (BAC) made two foolish acquisitions in 2008, and is now struggling with the dodgy housing assets of Countrywide Financial Corp. and the huge investment banking problems of Merrill Lynch & Co. Inc. (which is likely to make much less money in a deep recession than it could in a boom).

J.P. Morgan Chase & Co. (JPM), similarly, has huge investment banking businesses and large trading businesses; its businesses in consumer and small business lending are relatively modest. And the other two behemoths that now have conventional banking licenses, Morgan Stanley (MS) and Goldman Sachs Group Inc. (GS), still are primarily investment banks, with almost no consumer and small business banking operations.

Of the trillion-dollar guys, that leaves Wells Fargo & Co. (WFC). Wells Fargo needed money in 2008 – it got a $25 billion capital infusion from the Troubled Assets Relief Program (TARP) – because it bought the retail bank Wachovia Corp., which was struggling with its own problems.

Wachovia was in difficulty because of its foolish top-of-the-market purchase of housing lender Golden West Financial in 2006. However, the combined Wells Fargo/Wachovia unit remains primarily a consumer- and small-business-banking operation, with a huge nationwide branch network and a relatively small investment-banking business. What’s more, there are clearly costs that can come out of the merged group because of their overlap.

Wells Fargo Chairman Richard M. Kovacevich has made snotty comments about the “asinine” federal bank stress test, wants to repay the TARP money, and recently cut WFC’s dividend by 85% to conserve capital. However, if the combined bank is as profitable as it should be, Kovacevich may well be able to repay TARP and restore the bank’s dividend payout surprisingly quickly.

The current dividend yield at 1.5% is nothing to write home about, but at around 85% of tangible net asset value, Wells Fargo is a “Buy” – and don’t forget, if and when Kovacevich restores the dividend, that yield will jump to 9.8%.

Once you leave the trillion-dollar guys, there’s a big gap – the next-largest banks are The PNC Financial Services Group Inc. (PNC) and U.S. Bancorp (USB) at around $290 billion. These regional banks are generally more attractive currently – provided that their bad assets are under control and that they operate in an economically attractive part of the country.

These banks have little or no involvement in investment banking, and those banks that concentrate on mid-market corporate customers and high-quality consumers should have huge current earning capacity – a multiple of that before the meltdown. That will enable them to take care of further nasty surprises in their asset book and leave a lot over for investors.

Of the Top 12 U.S. banks I surveyed in a special Money Morning story a few weeks ago [actually 13, if you include a separate report I did on Fifth Third Bancorp (FITB)], PNC was among the riskier institutions because of its acquisition of National City Bank – an operation as large as itself and based primarily in troubled Ohio and Michigan.

Bank of New York Mellon Corp. (BK) and State Street Corp. (STT) are both oriented toward investment institutions and larger corporate and commercial clients, with perhaps less upside potential from the current steep yield curve. Other banks appear to be having more difficulty with their loan portfolios, or – as is the case with Capital One Financial Corp. (COF) – are have oriented themselves toward high-risk credit card lending, which may still show further problems.

Thus, my favorite profit play to emanate from this banking-ranking exercise is the Minneapolis-based U.S. Bancorp, which operates in the upper Midwest and Northwest from its home market of Minneapolis all the way through to Seattle, an area with neither huge industrial problems, nor the remnants of a huge housing bubble. USB has also cut its dividend and wants to repay its $6.6 billion TARP funding: U.S. Bancorp Chief Executive Officer Richard K. Davis has been as rude as Wells Fargo’s Kovacevich on that topic, calling it a “giant bait and switch.”

U.S. Bancorp is currently selling at 130% of tangible net asset value, with a current dividend yield of only 1.5%, but a potential yield of 14% if and when Davis manages to repay TARP and restore the dividend.

Remember, too: Banks traditionally sold at 250% to 300% of net asset value. Once their dividends are restored, Wells Fargo and U.S. Bancorp should have every chance of reaching that level again – they will deserve to on the basis of the dividend yield and earnings power alone.

It may take two years – or even three – but a capital gain of 100% or so, on top of a juicy dividend yield, will make it well worth the wait.

Source: As Resurgent U.S. Banks Shift Into Profit Mode, Hitch a Ride With These Two for Gangbuster Returns

The buck declined despite some upbeat news from the Institute for Supply Management. The ISM said nonmanufacturing sectors of the U.S. economy expanded during April after three months of contraction. Its services index rose to 52.0% from 49.6% in March. That handily beat economists’ projections for a decline to 49.4%.

Analysts believe traders were locking in their gains from last week’s rally, which was based on signals from the Federal Reserve that it is near the end of its interest-rate cuts. The dollar index, which charts the greenback against a basket of currencies, rose 2.5% last week.

Currency strategists at Brown Brothers Harriman are of the opinion that the “pieces of the puzzle we believe will contribute to a U.S. dollar uptrend this year are beginning to fall into place, but more pieces are needed for a more significant U.S. dollar rally.”

But the good feelings were diluted considerably by a report from the Federal Reserve on the credit crunch, which continues.

More than half of the banks surveyed by the Fed said they had tightened commercial and industrial loans, commercial real estate loans, residential mortgages, and home-equity lines of credit. Almost no banks eased credit terms for any type of loan, the Fed said in its quarterly senior loan officer survey.

“The significant tightening of standards for consumer loans is probably the ugliest news of this report,” wrote Harm Bandholz, of UniCredit Markets. “Investment will continue to shrink, while private consumption growth will come to a halt or even turn negative” in the second quarter.