Large regional banks are likely to get a boost from the Treasury's decision to pump $250 billion of badly needed equity into the troubled banking sector.

The federal government on Tuesday said it would allocate the funds from the $700 billion troubled asset relief program, or TARP, in a bid to improve investor confidence in the banking system by jump-starting the credit markets. Treasury Secretary Henry Paulson said early Tuesday that nine major financial institutions have already agreed to participate in the voluntary program, in which Treasury will buy preferred shares in the institutions.

"Although no definitive plans were announced regarding specific names in the regional space that will benefit, we believe it is just a matter of time before we see announcements benefiting the regionals in light of only 50% of the capital injection being used on the ... largest banks and fiduciary processors, so we expect the remainder will be applied to the regional bank space," writes Citigroup analysts Keith Horowitz and Greg Ketron.

Since the plan should have "significant impact" on the banking sector, Citigroup ( C) on Monday upgraded 12 banks to buy-rated stocks, including Comerica ( CMA), Regions Financial ( RF), SunTrust ( STI), Bank of America ( BAC), BB&T ( BBT), First Horizon ( FHN), Fifth Third ( FITB), Huntington Bancshares ( HBAN), KeyCorp ( KEY), Marshall & Ilsley ( MI), M&T Bank ( MTB), and Zions ( ZION), the analysts wrote in an industry note. Citi also raised its rating on U.S. Bancorp ( USB) to a hold.

"This is the most significant development to date in the sense that in one fell swoop Treasury has moved to address the greater issues of the day facing banks -- capital, liquidity in the form of depositor protection and the ability to issue debt," the note said. "Also unlike the prior plans which seemed more concerned about 'moral hazard' risks, this plan seems to more focused on encouraging private capital to start to flow back into the system."

The capital injection could also grease the wheels for acquisitions of regional banks, particularly as the housing and credit crisis extends both in longevity and beyond just subprime mortgages to include most forms of lending engaged by banks -- from credit card lending to prime mortgages to the beginnings of commercial lending troubles.

While the mid-cap banks have been less exposed to toxic securities dependent upon the mortgages underneath them, the banks are certainly exposed to housing- and consumer-related credit. For most small banks, mortgage banking and other types of lending are key parts of their business. As the credit boom expanded in the earlier part of the decade many banks began originating riskier loans and then selling them for securitization. The credit crisis has left more than one in dire straits as the credit markets seized up leaving bad mortgages on the banks' balance sheets.

In the last month alone two of the top ten largest banking institutions have been acquired -- JPMorgan Chase ( JPM) acquired much of Washington Mutual, which was seized by regulators last month after a run on deposits. Last week Wells Fargo ( WFC) won its battle with Citi to purchase southeastern powerhouse Wachovia ( WB).

Speculation is picking up that National City ( NCC), also hammered by the housing meltdown, is also looking for a buyer. Just Monday Banco Santander ( STD) announced plans to acquire the remaining portion that it does not already own of Sovereign Bancorp ( SOV) for $1.9 billion.

"In the case of Wells Fargo, there would be less question as to where it will get equity for its acquisition of Wachovia," writes Mike Mayo, an analyst at Deutsche Bank, in a note early Monday. "Citigroup will have equity to buy a regional bank. Other banks can potentially pursue bank acquisitions more easily with capital that is more readily accessible."

Reports have said that large banks including Goldman Sachs ( GS), Morgan Stanley ( MS), JPMorgan Chase, Citi, BofA (including recent acquisition Merrill Lynch ( MER)), Wells Fargo, Bank of New York Mellon ( BK) and State Street ( STT) are among the first recipients of government equity investments.

The same institutions also have agreed to a plan in which the Federal Deposit Insurance Corp. will temporarily guarantee the senior debt of all federally insured institutions and their holding companies, as well as deposits in non-interest bearing deposit transaction accounts in exchange for a greater supervision.

Under the Treasury's plan, announced early Monday, a qualifying financial institution may issue senior preferred equity that equals the lesser of 1% of its risk-weighted assets or $25 billion up to 3% of risk-weighted assets.

While regional banks were not included in the initial agreement, analysts say it won't be long before smaller banks take part in the equity infusion.

The government is "very cognizant that small banks want to participate," says Morgan Keegan senior bank analyst Robert Patten. "There is no doubt in my mind that the government is probably starting at the top and will work its way down. You need to make sure the largest banks are liquid."

Patten also upgraded several regional banks expected to benefit from the capital plan and FDIC initiative, including Fifth Third, SunTrust ( STI), Marshall & Ilsley, Synovus ( SNV) and Zions.

But Patten points out that there are limits to the use of capital.

Banks that participate in the initiative will need the approval of the Treasury to increase the dividend on its common stock. Among other details, banks will also need approval to buy back stock and will be required to scale back their executive compensation packages, according to terms of the deal.

"There are capital prohibitions," Patten says. "The primary use of this equity injection is to stabilize the industry, to remove the fear of who is going under, to add liquidity so that banks can start lending again."

That said, Patten acknowledges that one of the byproducts of the capital plan in the next two years will be to allow for stronger banks to acquire the weaker ones. But, at least in the near term, "that capital is meant to stay on the bank's balance sheet," he says.

Regional banks will also directly benefit from the FDIC's decision to guarantee short-term debt and temporarily back non-interest bearing deposit accounts, "which are normally larger valued business accounts, improves the perceived safety within the industry, especially those banks with high amounts of such funds," writes Oppenheimer analyst Terry McEvoy.

The moves by the Treasury and FDIC to alleviate the ongoing pain in the financial sector are notable and will likely result in a "reduction in the pace of negative rating actions" by Moody's Investor Services, due to the boosted capital levels at the banks. Still, analysts at the ratings agency do not expect that "these programs will provide a full resolution of the challenges facing the U.S. banking sector," according to an industry note.

"Poor operating results are expected at least through the balance of 2008 and well into 2009, with contraction of credit flows, both in response to recessionary condition and to improve bank balance sheet quality, affecting revenue and pre-provision profitability," Moody's says. "Further, problem assets will take time to work through the system and will provide a drag on bottom-line earnings for some time to come."

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