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As Warren Buffett once said, you never know who's been swimming au naturel until the tide goes out. And as investors have discovered, the U.S. banking system spent the better part of the past decade's housing bubble doing an underwater striptease. Now we're all getting an eyeful as banks, over-exposed to the sagging housing market, make a mad dash for cover.
Even with the U.S. government's takeover of ailing mortgage lenders Fannie Mae and Freddie Mac, banks will continue to turn up bare until the housing tide turns. From a locally originated mortgage held by a small bank to an esoteric debt security on the balance sheet of an investment bank, a loan is only as good as the collateral that backs it. And that collateral has been in a dizzying freefall.
But there are reasons to be optimistic about bank stocks. Chief among them: The decline in home prices is slowing. The Case-Shiller index of home prices in 20 major metropolitan areas is down 19% from its peak in July 2006, but its month-to-month decline peaked in February at 3% and has slowed each month since. In May, seven of the 20 markets saw an increase in prices, and in June, ten of 20 did. Moreover, the bailout of Fannie and Freddie should lead to lower mortgage rates, which should boost demand for homes.
That's not to say that home prices have bottomed, but they don't need to for bank stocks to stage a comeback. After all, the stock market is forward-looking, and stock prices tend to reflect economic trends before the data confirms them. "We're far enough into the problem that reasonable people can place parameters around the range of expected losses," says Tom Brown, a hedge-fund manager who operates the Bankstocks.com Web site.
Still, because banks run on borrowed money, a small margin of error can quickly expand to a gulf. Plus, bank executives have broad discretion as to how much detail they disclose about their holdings of mortgages and other assets. That's why banks are often called black boxes. Below, we suggest opportunities among three broad swaths of the banking sector: investment banks, which help businesses and government entities raise funds; money-center banks, national institutions that often combine the roles of both traditional banking and investment banking; and small, regional banks.
We've homed in on those banks strong enough to wrest market share from their bludgeoned rivals. That way, regardless of when stock prices recover, the piece of the business you own will be larger next year than it is today. As any former Bear Stearns shareholder could tell you, just because a stock is dirt-cheap today doesn't mean it won't be cheaper than dirt tomorrow.
Large and in charge
As a group, the money-center banks offer the biggest opportunities. Many boast immense deposit franchises, which offer a low-cost source of funding that won't dry up overnight. And because these guys are part investment bank and part commercial bank, they rely on diverse sources of revenue -- bringing in bucks from buyouts across the globe and the ATM down the street.
Straddling the divide between investment bank and brick-and-mortar bank, JPMorgan Chase & Co. (symbol JPM) is scooping up new business with ease. Its already formidable investment-banking division gained market share for a song with the company's acquisition of Bear Stearns in May for $2.2 billion. Standard & Poor's analyst Stuart Plesser says he can see evidence of JPMorgan's increasing share in residential and commercial mortgages and in consumer banking. "Particularly in the commercial area, companies want to work with a strong bank that they know they're not going to have to worry about," he says.
Management's openness about troubled assets earns it extra credibility. "I think they've been the most forthright in the industry about their problems," Plesser says. The company has been much more aggressive in shoring up its cash reserves and balance sheet than some other banks, he says. At $40, the stock is down a relatively modest 9% for the year. It trades at 12 times estimated 2009 earnings of $3.29 per share.
A strong deposit base can provide a floor for banks with a high exposure to risky loans. "There's nothing you can do with wacky accounting rules to change the fact that deposits are deposits," says Ladenburg Thalmann & Co. analyst Dick Bove. With deposits of $785 billion, Bank of America (BAC) accounts for nearly 10% of all U.S. bank deposits. Jeff Arricale, manager of T. Rowe Price Financial Services fund, says that customers are moving to Bank of America in a flight to quality, and "it has the pick of the litter in terms of making loans."
The company's outsized book of loans may still cause it some pain. Bank of America has a $120-billion home-equity portfolio and a $62-billion U.S. credit-card-loan portfolio. It finished its $3-billion acquisition of distressed mortgage lender Countrywide Financial in July, making BofA the nation's biggest mortgage lender. Although Countrywide lost $2.3 billion in the second quarter, BofA executives say they expect the mortgage lender to contribute positively to profits before the end of 2008.
At least the behemoth is already near its floor. Bove figures that Bank of America is conservatively worth at least 15% of its deposits. At a price of $32, the stock trades for 19% of the value of BofA's deposits. The price-earnings ratio, based on forecasted 2009 profits of $3.29 per share, is 10.
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