Wednesday, October 19, 2011

What to do about Bank Stocks?

I first wrote about this topic last March. Fortunately, I concluded that it was not yet time to dive into the sector, despite the fact that the valuations appeared very attractive.

Here's what I wrote then:

Problem now is that the very same problems that nearly destroyed the system are still very much evident. There still remain thousands, if not millions, of home mortgage loans that are underwater, and the outlook for housing is still very poor, in my opinion. Derivative products tied to mortgage loans also are pervasive in the system.

Then there's the problem of growth. Speaking as someone who works at a bank, we have lots of money to lend, but face a real paucity of credit-worthy borrowers. This is part of the problem the Fed is facing, by the way: the central bank can keep adding money to the system, but it is largely being reinvested in Treasurys, which doesn't do too much to either help the economy (or help bank profits, for that matter).

Lots has happened in the last 6 months, but nothing (in my opinion) has changed in terms of the headwinds facing my industry.

Loan growth remains sluggish. Low interest rates are killing bank net interest markets. Credit metrics for the banks are starting to show deterioration again, after several quarters of improvements.

And recent results from the money center banks appear attractive, yet once you dive into the numbers much of the recent bank profitability has been achieved through "special items".

Consider Bank of America, which posted stronger results than expected, and BAC soared by +10%. However, according to this morning's New York Times:

Still, the story behind {Bank of America's} $6.23 billion profit was mostly a tale of one-time gains from accounting changes and asset sales, including $4.5 billion from positive adjustments to the value of its outstanding debt, a $1.7 billion accounting gain on the perceived riskiness of its debt and a pretax gain of $3.6 billion from the sale of half its stake in China Construction Bank....

Without the special items, Bank of America would have earned about $2.7 billion, which included pulling back $1.7 billion it had set aside, largely for borrowers who fail to pay their consumer and credit card loans.

Jason Goldberg, an analyst with Barclays Capital, counted 15 special items in the quarter, down from 16 in the second quarter but more than the 12 in the first quarter. “It’s a big company undergoing a transformation.”

Now, I am a fan of Jason Goldberg, but is it really a positive that the number of special items in Bank of America's earnings has fallen from 16 "one-off" items to 15?

Then there's this: I asked Rich Sipley, a fellow portfolio manager here at Boston Private Bank (and loyal reader of Random Glenings) a simple question yesterday.

Me: "If bank stocks are so cheap, why are we seeing more acquistions?"

Rich: "No one wants to sell at these prices."

That's why Rich is a good portfolio manager.

That said, there is more feelings that the longer term outlook is for a large increase in bank merger activity, simply because the costs of banking in this country are rising significantly at a time when revenue growth has been nonexistent.

This morning's Financial Times carried a piece this morning discussing the need for the banking sector to shrink in the U.S.

According to the article, a recent report by turnaround specialists Alvarez & Maral suggests that large U.S. regional banks will "need to cut expenses by up to 40% to cope with slower economic growth, increasing pressure to cut staff or merge with rivals".

Here's the problem:

Companies such as Regions Financials - which is trading at about a third of its book value - and Sun-Trust banks - trading at about half of its book value - will be among those facing pressure either to pare back their operations significantly or merge with competitors. Many already have announced cost-cutting measures to placate investors.

From 2002 to 2006, banks' ROE was about twice as high as their cost of equity capital, according to Alvarez & Marsal. Since 2008, the cost has exceeded the return, a trend that is forecast to continue until 2013.

So for now I remain very defensive in my bank positions in portfolios.