A Pre-Earnings Look At The Banking Environment

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As we sputter toward earnings season for big banks, it bears noting that the average American bank stock is still trading 58% below its level of February, 2007. That is despite an average 24% advance thus far in 2012. What has been clear since the bottom of the market in early 2009 is that the banking industry has some clear winners and losers, and some that are stuck somewhere in the middle. Regulatory changes have put additional stress on the sector. Before the release of third quarter earnings, I wanted to look at the industry as opposed to specific companies to see what has separated the winners from the losers, and what the near term future is likely to hold.

The numbers we are talking about are staggering. Between February, 2007 and February, 2009, the S&P 500 Financial Index lost nearly $2.5 trillion in value. Between 2007 and 2009, the finance companies in that index wrote down $2.1 trillion of bad loans.

In the here and now, what I believe will separate winners from losers is any institution's focus on traditional banking activities. These winning banks have expansive domestic branch networks, limited trading operations or foreign assets, and a focus on growing their loan portfolios. Losers are either still encumbered either in reality or psychologically from the trauma of late last decade, have substantial trading operations, or substantial exposure to uncertain European economies.

Among the biggest banks, winners have included Wells Fargo (WFC) and U.S. Bancorp (USB). Each of these came through the recessionary years relatively unscathed, picked up other troubled banks on the cheap, and grew without sacrificing profitability. Each sport returns on assets well over 1% every quarter, have generous reserves established, and competitive, or better, efficiency ratios. Each pays an above average dividend yield, to boot.

The fact that banks have been under pressure to devote their profits first, toward increased equity, and second, toward returns to shareholders has been, in my opinion, a hindrance against the recovery of the larger economy. If the cumulative hundreds of billions of dollars had been reinvested in the economy rather than reinvested in balance sheets and taxable dividends, who knows how much better off the “Main Streets” might be today.

There have been recent reports of something I believe endemic to the banking industry. That is, the manipulation of earnings for reporting reasons. Nearly all large banks over reserved for loan losses last decade, allowing the falsely positive earnings reports we have seen resulting from cuts in loan loss provisions and reversals in those reserve provisions the past two years. Revaluations of credit and debit portfolios is another way to manipulate income. It would not surprise me that more than 20% of banks “cook their books” for reporting purposes.

Of course, there are numerous other regional banks on the winning side of the equation. North Carolina based BB&T (NYSE: BBT) claims it never wanted TARP funds, but was forced to accept the investment. In addition to its ownership of a burgeoning insurance agency, BB&T's loans outstanding grew by $8 billion, or 8% from June 30, 2011 to June 30, 2012. Every bank is having issues with margin pressure as interest rates remain artificially depressed. Loan growth is therefore the only way to increase, or even maintain net interest revenue.

Bank of Hawaii (NYSE: BOH) is another smaller regional bank with a winning formula. Not once as far back as I can track, since 1997 has it ever had a return on assets of less than one percent. By its own standards, it has not truly recovered from the recession, and its returns in recent years have been far closer to 1.0% than its historical average of about 1.6%. Therefore, this bank has room for improvement. In the near term, pressures on the bank's ability to maintain its interest margin will make earnings increases difficult. But management has been buying back shares and its dividend yield of near 4% will provide support in the near term. In the long run, the tourism and real estate that support much of the Hawaiian economy will eventually recover. I like Bank of Hawaii for income oriented investors. 

On the rougher side, we have the big losers of the last five years; Citigroup (NYSE: C) and Bank of America (NYSE: BAC). These institutions are now selling for about 95% less and 85% less, respectively, of their early 2007 stock prices. And though both may be in for a bounce if their earnings can stabilize beyond one-time factors, it will still be years before either approaches the levels of profitability and stock valuation they enjoyed last decade. Also, most of the nation's larger banks have either recently settled or been sued civilly for mortgage fraud stemming from last decade's excesses. Both Citigroup and Bank of America have some appeal, but only for the risk tolerant investor.

Between these winners and losers are the banks that suffered mightily late last decade, but have shown a comeback toward historic levels of profitability. Among the top twenty American based banks by assets, I put PNC Financial Services (PNC) and Fifth Third (FITB) among the banks in that group. Both of these banks have managed to reestablish profitability above a 1% return on assets of late, yet there are clear signs of stress from these banks about their near term profitability due to the long term interest rate environment. It will be a fun earnings season, and as banks release earnings, the quality of their bottom lines will be every bit as important as the quantity. Interest rates are not going up any time soon, and how banks manage to maintain interest income will be key going forward.

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StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Bank of Hawaii, and Citigroup Inc. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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