Wednesday, August 20, 2008

The Bank Job

I like banks. They tend to smell good inside. Many have free popcorn in their lobbies. Most have a few attractive tellers, and there's nothing quite like a beautiful woman handing you a stack of crisp fifties. Plus banks have a financial model that really appeals to me.

Consider how they make money:

1. Banks offer to hold your cash at a very low rate of interest. In some cases, they pay no interest at all.

2. The bank, using your cash, makes loans at a significantly higher rate of interest.

All the bank has to do is lend at a high enough average rate to allow it to pay its lenders, meet its expenses and cover bad loans. That's it. Borrow low, lend high, pocket the spread. Simple but elegant.

On the whole, banks are extremely good at this. Damn good.

Consider: If a bank makes $1 billion in loans at 8.25% and pay 4.50% in interest -- holding back 2% of the total to cover any loan losses -- it will turn a gross profit of $17.5 million. That's before it has touched expenses, sure, but it's also before it has collected any service fees. (And my friends, banks across these fruited plains collected $9.9 billion in fees on deposit accounts last year alone.)

But a billion dollars in loans is chump change. Banks have $6.5 trillion in outstanding loans. That's half the U.S. gross domestic product and about a tenth of the entire world's. This is what the business gurus at the Wharton School and the Friedman disciples at the University of Chicago refer to as a shitload of money.

But investors who own bank stocks are having a tough slog. Even though a mere two-point spread on $6.5 trillion in loans is $130 billion in net interest income, no one cares. No one is focusing on the overall health of the banking sector only on the ravages of subprime. To wit: Keefe Bruyette & Woods' Bank Index is off -30.6% year to date and off -43.4% from a year ago.

The biggest banks -- J.P. Morgan, B of A and Citi -- have seen scores of billions in market capitalization evaporate as the financial sector reels from the subprime mess, credit crunch and resultant stagnant economy. Citi is off -40% for the year, B of A -30% and JP Morgan about -10% Banking is ultimately risk management, and the best risk manager in the game is Wells Fargo. Wall Street has rewarded Wells, which had almost no exposure to subprime, with a flat stock price.

Consider "beta." This metric uses a bunch of whiz-bang statistical applesauce to compare a stock's price volatility to the broad market. A beta of 1.00 means a company's stock moves in lockstep with the market as a whole. It is a measure of relative risk. Citi's beta is 1.48. So is Wachovia's. That means that investors consider two of the largest banks in the country to be half again as risky as they overall stock market. That's amazing. Without knowing any of the details, would you rather bet on the bank you trust your money to or any stock in the S&P 500?

Now, admittedly, not all banks have a huge beta, but the sector is unquestionably decimated -- "quadrimated," for the literal. The reason is simple: Investors are simply scared shitless of banks. (It's mutual: Banks are scared shitless of investors right now. And a lot of banks are scared shitless of borrowers right now) Investors are terrified that major financial institutions are going to announce more losses and writedowns. The No. 1 most-read story on the Bloomberg yesterday was about the possibility of a big bank failure.

With prices in the toilet, bottom-feeding speculators move in to take advantage. But these guys are basing buy decisons on price alone -- they're just looking at a price chart. So when some sort of bad news or rumor hits the Street, they bail. Prices start to fall, and this leads other investors to dump shares, which pushes prices down further.

So for every step forward that the financial sector manages to take at the beginning of the week, most issues seem to wind up knocked back at least as far by the end of the week. Bank shares can't gain traction because no one knows what is going to happen.

Well, I do.

That business model I showed you? Banks really aren't any more complicated than that. Oh, sure, there are some nuances, but the question of whether banks' business model is sustainable has long been settled. Banks will do just fine. In fact, banks are doing just fine -- in aggregate.

True, some banks made lousy lending decisions, and they will fail. Hey, life's rough in the aluminum-siding business. Other banks will tread water indefinitely. But many banks, perhaps even the majority of banks, will see their stock prices regain their footing. Just putting the index back where it was a year ago implies a +56% gain. Some say that may take two years. Hmm, OK. I'd sure be satified with +28% a year -- that's twice the S&P. That's better than the Harvard Endowment. (See yesterday's post)

Let's look at the numbers. I went to the FDIC and reviewed bank financial data to see what was going on. Banks have to report everything to the FDIC. It tends to keep a close eye on the details, as it's on the hook for trillions in deposits. According to the FDIC, banks have $11.5 trillion in assets and $6.5 trillion in net loans -- in fact, banks have 11.2% more loans now than they did at this time last year.

$106 billion in credits were classified as noncurrent, while $102 billion in cash was held in reserve to cover uncollectible loans. That means banks have less cash on hand as they have classified loans -- it should be the other way around. Even last year, banks had 1.4 times classified loans in reserve. Two things have changed that: More bad loans and more conservative classification.

But that's glass half-empty. Glass half-full: Not all classifed loans will go belly up, and banks still have $6.4 trillion in performing loans that are generating serious income.

Now, additional loan losses are inevitable. Classified loans are up +115%, and that's serious. Banks have upped loss reserves +48% since last year to deal with this, and they may need all of that and still more. We'll see. But bad loans and asset writedowns, which have the same effect on the bottom line, are a cost of doing business. Both of these factors will affect earnings for a while.

But did I mention the $6.4 trillion in loans that's still doing just fine? Isn't that the real point here? Banks are fundamentally sound. Banks have a solid, proven business model. Banks can still generate a lot of cash. As bank shares fail to gain traction and continue to move sideways, smart investors should take advantage. The prices are just too low to resist. Citi, JP Morgan, B of A, Wachovia, CIT they are trading for less than the value of their assets -- you can buy assets at Wachovia for 47 cents on the dollar. If that were true at the Lexus dealership, you'd show up with a fleet of semis, right? To sell the cars later? That's exactly what you should be doing with bank shares right now.

It doesn't take a lot of looking to find a bank with appealing fundamentals and a ridiculously low price. Large banks, small banks, super regional banks -- all are target-rich environments. Even so, I'm not going to recommend a specific bank because we looked at aggregate numbers. If we buy the thesis from aggregate data, then we need to play macro rather than micro and buy the sector. The best way to do that is an ETF that owns a basket of bank and financial stocks.

I like the Financial Select Secotr SPDR, which trades under the ticker XLF. It owns about 90 stocks, and it's down -31% year to date and -41% for the past 12 months. This gives it +45% in upside just to get back to where it was on Jan.1.

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