Will First-Half Gains Give Way to Second-Half Pain?

[Editor’s Note: After more than a year of chaos and controversy, some of the leading U.S. banks saw their stock prices soar during the second quarter. As part of its mid-year forecast series, Money Morning examines the outlook for U.S. banks for the rest of this year. To see earlier stories from our mid-year forecast series, please click here.] By Martin Hutchinson Contributing Editor Money Morning

Can U.S. bank stocks continue their winning streak?

In February, I analyzed the top 12 U.S. banks to determine whether they really needed $1.5 trillion in taxpayer-provided bailout capital. I concluded that only a few of those banks seemed to be in any danger of collapse, and actually recommended several.

Policymakers and the market later came to agree with me: The Standard & Poor’s 500 Financial Index has more than doubled from its March low and several bank stocks have posted triple-digit returns.

An April review of the first-quarter financial results of the top 13 U.S. banks (I added Fifth Third Bancorp (NYSE: FITB), at a reader’s request, to make it a Baker’s Dozen) only reinforced my conclusions.

But now the second-quarter results are out and an examination of those financial statements makes it appear this optimism may have gone too far. And that could mean that bank stocks will pose more risk in the year’s second half than they did in the first six months of 2009.

Let’s take a closer look.

Stressed Out Over Stress Tests

The highly controversial government bank “stress tests” may be the best place to start. Since the results of the government stress tests (Money Morning conducted bank stress tests of its own) were published, a number of banks raised extra capital.

However, it’s now clear that the government’s stress tests may not have been stressful enough.

The government’s “more adverse” scenario postulated unemployment averaging 8.8% in 2009 and 10.3% in 2010. With unemployment already at 9.5% in June we have blown through the 2009 estimates. And with some economists actually projecting that unemployment could actually reach the 12% level next year, the government estimates for 2010 were clearly also too low.

Furthermore, neither scenario considered what might happen as a result of the enormous budget deficits, currently forecast at $1.8 trillion in 2009 and $1.3 trillion in 2010. If interest rates zoom up, bank profits will take an additional hit. On the other hand, the “more adverse” scenario assumed a 22% decline in house prices in 2009, followed by a gain of 7% next year. Recent good news in housing suggests those figures may indeed be a bit pessimistic. Overall, therefore, the fact that a bank passed the stress test is not a guarantee of future success.

Goldman Sachs Group Inc. (NYSE: GS) and Morgan Stanley Inc. (NYSE: MS) – onetime investment banks now operating as bank holding companies – fall into a separate category. Both institutions depend almost entirely on their trading prowess, which in the case of Goldman Sachs produced impressive results in the second quarter. However, I am old-fashioned enough to regard what they do as not really banking, and hence propose to ignore them in this piece.

The Indicators That Separate Winners From Losers

There is lots of information – about potential bailout needs and about possible investment bargains – that can be gleaned from the banks’ second-quarter figures and from the earlier government “stress test” results. In particular:

A number of banks did fine on the stress tests, but then went on to report thumping losses in the second quarter, suggesting the stress tests were wrong (my own ratings seem to have been more accurate!).

  • Banks that have lost money at an operating level in each of the last three quarters are probably in terminal trouble, regardless of whether the “stress test” said they were okay.
  • Banks that relied more on the Goldman-Sachs-type trading business had better quarters than the banks that relied upon more-traditional lending. I regard this as a danger sign, since that business is likely to be much less profitable going forward and some products (credit default swaps, for example) may land an institution in serious trouble. What’s more, it now appears that commodities trading is poised to come under political fire, particularly since it appears that regulators are looking to restrict risk.
  • In most cases, such key financial-analysis ratios as stock price to book value (Price/Book ratio, or P/B ratio) have risen sharply in the last few weeks. If the bank is trading above book value, but is still making losses or tiny profits, it’s overvalued.
  • Several banks did share issues at huge discounts to book value, badly diluting existing shareholders. As far as I’m concerned, any bank that has a management team that’s hostile to shareholders is a bank to avoid.
  • None of the banks seem likely to pay reasonable dividends going forward, though BB&T Corp. (NYSE: BBT) is at least making an effort, with a dividend yield of around 2.7%. Over the long term, dividends are a key component of investment returns, so they should always be a consideration.

The Four Categories of U.S. Banks

Using these indicators, we can assess the viability of the leading U.S. banks. They can be divided, as before into four categories:

  • Zombies: Institutions making persistent losses at an operating level. These subtract value from the economy and should be put out of their misery through controlled liquidation, with the healthy parts being salvaged. They are surviving only because of ill-advised government (taxpayer) largesse.
  • Walking wounded: These may well need another bailout if troubles develop. Right now, however, despite the fact that profits are too low, these banks are currently operating adequately on their own. An intensification of economic downturn would push some of them into “zombie” status or bankruptcy.
  • Risky but Proud: These banks have relatively high risks, because of acquisitions or their business mix, but appear to be overcoming the challenges they face. However, their profitability is poor and may remain so.
  • Hidden gems: These banks have conquered 2008’s difficulties, taken care of their bad-debt problem, and still managed to make a substantial profit. Short of a repeat of 1929-33, they should continue to do so. However, many have seen their stocks soar, meaning their shares are often now overpriced – especially given the likelihood of a prolonged recession still to come.

A Baker’s Dozen for Bank Investors

That brings to a review of the 13-largest U.S. banks by assets as of Dec. 31 (ignoring Goldman Sachs, Morgan Stanley, and foreign-owned banks). They are listed here in reverse order of size (as measured by assets):

13. Fifth Third Bancorp (Nasdaq: FITB) – Zombie: With $120 billion in assets, this Cincinnati-based regional bank accepted a $3.4 billion Troubled Assets Relief Program (TARP) investment from the federal government. Fifth Third grew by buying other banks in the Midwest and Florida. At Monday’s closing price of $8.67 a share, the bank is trading at 67% of book value and twice its level of three months ago. It lost $1.2 billion in 2008 even after goodwill write-offs, and has lost another $26 million in the first quarter of 2009 – a bad result, since the 2008 disaster and the TARP investment should have allowed it to mark down its bad assets, taking “everything but the kitchen sink” into the 2008 loss. It posted an additional operating loss of $200 million in the second quarter, but showed a profit because of a $1.1 billion sale of its processing unit. Stress test said it needed another $1.1 billion of capital, which it raised through the dilutive sale of $1 billion in stock, as well as the asset sale. Fifth Third’s survival as an independent entity – without further state assistance – remains doubtful; an orderly liquidation would seem the best alternative. However, both the Ohio economy, and the U.S. housing market – both major problems for FITB – are looking better. Second-half rating: AVOID.

12. Regions Financial Corp. (NYSE: RF) – Zombie: With $146 billion in assets, and a $3.5 billion TARP investment, this Birmingham-based regional bank operates primarily in the Southeast. At Monday’s closing price of $3.69, Regions’ shares are trading at 28% of book value. The bank lost $5.6 billion in 2008, and its tangible net worth is only $10.5 billion, but that loss was based entirely on goodwill impairment; on an operating basis it made a profit of about $300 million. Regions earned $77 million in the first quarter, but lost $244 million in second quarter. According to the federal stress test, Regions needed $2.5 billion; it raised $2.1 billion through equity issues, thus diluting the hell out of existing shareholders. I have downgraded it from Walking Wounded to Zombie, although there may still be a pulse there. Second-half rating: AVOID.

11. BB&T Corp. (NYSE: BBT) – Hidden Gem: With $152 billion in assets, this Winston-Salem, NC-based regional bank operates mostly in the Mid-Atlantic region. At Monday’s closing price $21.62, BB&T was trading at about 90% of book value. This bank was profitable in each quarter of 2008, as well as in both quarters so far this year, making $1.5 billion for all of last year, $271 million in this year’s first quarter and $208 million in the second quarter. BB&T “aced” the government stress test, sold $1.7 billion in common stock and repaid its TARP funding. It cut quarterly dividend to 15 cents a share for second quarter of 2009 and it will be interesting to see what it does going forward. The shares are up more than 50% since I highlighted BB&T as one of the three U.S. banks that posed plenty of promise with very little downside risk. However, the stock-price increase since spring doesn’t reflect BB&T’s truly superior performance, which should improve now that it’s rid of TARP. Second-half rating: BUY.

10. Capital One Financial Corp. (NYSE: COF) – Zombie: Based in McLean, Va., Capital One is primarily a credit-card operation, though it has also acquired banking operations. Total assets equal $161 billion. It has repaid its $3.5 billion TARP investment. Because of its large market share with aggressive lending practices, Capital One looks to me like the credit card equivalent of the formerly independent mortgage lender Countrywide Financial Corp., which is now part of Bank of America Corp. (NYSE: BAC). At Monday’s closing price of $29.79, Capital One was trading at 53% of book value. It lost $1.4 billion in fourth quarter of 2008, $112 million in first quarter of 2009, and $275 million in second quarter. The second-quarter loss included the alleged $453 million cost of repaying TARP, but also a negative write-down on its credit-card portfolio. Stress test said it was fine; an extraordinary view, so it issued $1.5 billion of very-dilutive shares and repaid TARP. I don’t like the business and I don’t trust the accounting. Second-half rating: AVOID.

9. State Street Corp. (NYSE: STT) – Risky but Proud: A Boston-based bank, with a uniquely institutional orientation, State Street has $174 billion in assets, and repaid its $2 billion TARP investment. At Monday’s close, its share price was $48 – an extremely rich 199% of book value. State Street has $2 billion in (non-dilutive) stock to repay TARP. Last year’s reported per-share earnings of $3.89 represented a 13% increase from 2007. Its first-quarter net income fell 16%, but was still $445 million. However, State Street posted a second-quarter loss of $3.3 billion after a $6.3 billion charge that was related to its asset-backed commercial paper (ABCP) program. Although the government stress test said State Street was fine, those conclusions were made before the ABCP loss. Rating cut a notch; one worries how many other banks have this kind of disaster lurking somewhere. Way overpriced. Second-half rating: AVOID.

8. SunTrust Banks Inc. (NYSE: STI) – Walking Wounded, but on a path to Zombification: Based in Atlanta, this regional bank has $189 billion in assets and operations throughout the Mid-Atlantic region, as well as throughout the Southeast – particularly in Florida. SunTrust accepted a $4.9 billion TARP investment. At Monday’s closing price of $18, SunTrust was trading at 47% of book value. It posted a fourth-quarter loss of $379 million, but an overall 2008 profit of $747 million. However, SunTrust’s first-quarter loss of $815 million included $715 million of mortgage and real-estate-loan losses and it posted a second-quarter loss of $184 million. The stress test concluded it needed $2.2 billion in additional capital, which it raised by a share issue, heavily diluting existing shareholders. SunTrust has not been permitted to repay TARP. Second-half rating: AVOID.

7. The Bank of New York Mellon Corp. (NYSE: BK) – Hidden Gem: A New York-based bank with operations primarily in New York and Pennsylvania, and an institutional/corporate business orientation, Mellon has $237 billion in assets and repaid its TARP investment. Monday’s closing price of $27 meant the bank was trading at 119% of book value. It passed the stress test. Net income for 2008 was $1.39 billion and it reported a first-quarter profit of $322 million, after which bank reduced its quarterly dividend from 24 cents to 9 cents. It posted a second-quarter profit of $176 million after a $196.5 million charge for TARP repayment costs. Bank of New York Mellon raised $1.5 billion of subordinated debt and $1.4 billion of non-dilutive equity to repay TARP. This looks solid to me, with profits steady if you add back the TARP repayment cost. Second-half rating: BUY.

6. U.S. Bancorp (NYSE: USB) – Hidden Gem: With $266 billion in assets, this Minneapolis-based regional bank operates mostly in the Northwest and Upper Midwest. It has repaid its TARP investment. Monday’s closing price of $20 a share meant the bank was trading at 169% of book value. It reported a profit of $2.94 billion for all of 2008. It posted a first-quarter profit $419 million, and a second-quarter profit of $221 million after a $154 million TARP repayment charge. It passed the stress test. It issued $1 billion of debt and $2.7 billion of non-dilutive equity. It cut its quarterly dividend from 42.5 cents per common share to 5 cents to repay TARP. Second-half rating: HOLD.

5. PNC Financial Services Group Inc. (NYSE: PNC) – Hidden Gem: With $291 billion in assets, this Pittsburgh-based bank bought the slightly larger Cleveland-based National City Corp. in October, and now operates in the Mid-Atlantic and Midwest regions. It accepted a $7.6 billion TARP investment. At Monday’s closing price of $35, PNC is trading at 84% of book value. It reported net income of $882 million for 2008, $460 million for first quarter of 2009 and $207 million for second quarter of 2009. PNC’s quarterly dividend is now 10 cents per common share. The bank raised $600 million as required under TARP, with only small dilution. PNC appears to be integrating its National City acquisition well, but remains concerned about possible deteriorations in its credit quality. It plans to redeem TARP in a “shareholder-friendly manner.” I’ve upgraded this to a Hidden Gem on the basis of continued earnings and a reasonable stock price. Second-half rating: BUY.

4. Wells Fargo & Co. (NYSE: WFC) – Risky but Proud: A San Francisco-based bank that’s evolved into a nationwide player following its buyout of Wachovia Corp., Wells Fargo has $1.31 trillion in assets, and accepted a $25 billion TARP investment. Monday’s closing price of $24 means the stock is trading at 135% of book value. Wells reported a fourth-quarter net loss of $2.55 billion, not including an $11 billion net loss at Wachovia; full-year 2008 earnings totaled $2.84 billion. So far this year, Wells has reported a first-quarter profit of $2.38 billion, and a second-quarter profit related to common stock of $2.58 billion. The bank cut its dividend to 5 cents per share. The government stress test concluded that Wells Fargo required an additional $13.7 billion, which it raised via $8.6 billion in outside equity and $5 billion from internal sources. Wells now looks riskier than PNC; its loan write-offs in the second quarter exceeded loan-loss provisions. Second-half rating: HOLD.

3. Citigroup Inc. (NYSE: C) – Zombie: For regulators, Citi is the Big Kuhuna, and in my opinion, it should have been liquidated. A global financial conglomerate based in New York, Citigroup has been a serial flirter with bankruptcy over the last 30 years. Citi right now has $1.945 trillion in assets, and accepted both a $45 billion TARP investment, and government guarantees on $301 billion of assets. At Monday’s close of $2.86 per share, Citi is trading at 19% of book value. It lost $18.7 billion in 2008. It theoretically made money in the first quarter of 2009, but then fell back to a loss because it had to re-set the terms of some preference shares issued the previous year, diluting common shareholders further. Its $11.1 billion gain from the sale of its Smith Barney brokerage gave it a $4.3 billion second quarter profit, but Citi still lost oodles on an operating basis. The banking giant swapped $58 billion of preference shares for common, which will dilute shareholders still further. And it reduced its dividend to a nominal 1 cent per share. This is the Zombie of Zombies, and seems to be getting no better. Second-half rating: AVOID – though, as a taxpayer, you own 34% of it, anyway.

2. JPMorgan Chase & Co. Inc. (NYSE: JPM) – Risky but Proud: With $2.175 trillion in assets, JPMorgan is a major international player with a New York headquarters and its banking and investment-banking operations are both major global players. It bought The Bear Stearns Cos. Inc. investment bank in March 2008 and the Washington Mutual Inc. (OTC: WAMUQ) thrift in September, both with federal government help. It has paid back its TARP investment. Monday’s closing price of $38 meant that JPMorgan was trading at about 102% of net asset value. It reported net income of $5.6 billion for 2008. So far this year it reported $2.1 billion in first quarter and $2.8 billion in second quarter – after TARP repayment costs of more than $2 billion. JPMorgan reduced its quarterly dividend from 38 cents per share to 5 cents a share. However, the second-quarter profit was largely from investment banking, which I view as very low quality earnings, though JPM gains from lack of competitors currently. Second-half rating: HOLD.

1. Bank of America Corp. (NYSE: BAC)Zombie: With roughly $2.8 trillion in assets – including Merrill Lynch, which was acquired after the 2008 year-end – this nationwide retail-banking giant is based in Charlotte, and has used the financial crisis to grow through acquisitions. In addition to its purchase of Merrill, the No. 3 investment bank, BofA also purchased No. 1 mortgage giant Countrywide mark-to-market” write-up of Merrill Lynch debt (the opposite of all those “mark to market” write-downs banks are whining about). It reduced its quarterly dividend to a nominal 1 cent per share. Second-quarter net income of $3.2 billion was after $9.1 billion of pre-tax gains from asset sales, so on an operating basis it still loses money. It’s still a Zombie, and I question the quality of its management. Still a Zombie, and management quality is doubtful. Second-half rating: AVOID.

Financial Corp. last year. Bank of American accepted a total TARP investment of $45 billion, as well as $118 billion in asset guarantees against Merrill Lynch assets. Monday’s closing price of $13 meant that BofA was trading at 50% of book value. The banking giant reported a fourth-quarter net loss of $1.55 billion, and had to shoulder the additional Merrill Lynch net loss of $15.3 billion. Bank of America reported a first-quarter profit of $2.8 billion after preferred-share dividends, but that included $2.2 ”

A Final Look Forward

From this extensive analysis, it’s very clear that the leading U.S. banks are still very troubled, and that several lf them will probably have to be liquidated over time or taken into public ownership. In fact, in many ways the continued virulence of the problems in this sector make me even less optimistic than in February. In particular, the government’s decision to allow Citigroup and perhaps even Bank of America to continue operating causes a huge moral hazard: As a Money Morning investigation demonstrated, banks will take endless risks and merge like madmen in order to be thought “too big to fail.”

There’s another problem – this one of particular concern to current stockholders, or prospective investors: The downside risks for all these banks now exceeds the upside.

Many of these banks have experienced huge share-price run-ups. Take Bank of America. At the closing price of $13.34 yesterday, BofA’s shares have soared more than 320% from their early-March lows. Looking ahead, the liquidity growth in the U.S. monetary system has been so excessive, and the projected U.S. federal budget deficit is so great, that there must be a substantial chance of a bond market crash in the months ahead. That would undoubtedly hit some of these banks hard, possibly pushing them over the edge – but there’s no way of figuring out which. So, in general, I would give the sector a miss.

[Editor’s Note: When it comes to global investing, longtime market guru Martin Hutchinson is one of the very best – because he knows the markets firsthand. After years of advising government finance ministers, crafting deals with global investment banks, and analyzing the world’s financial markets, Hutchinson has used his creative insights to create a trading service for savvy investors.

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