Are These 4 Well-Capitalized Banks Buys?

Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Editor's Note: Per First Financial's Investor Relations website, their dividend yield is 7.76%. This version has been corrected.

I learned of some disturbing news. That is the international commission that devises the Basel capitalization standards for banks is retreating from its Basel III standards. That is, not the 8% capital per se, but rather, liquidity issues that accompany specific capital ratios. The liquidity measure standard of High Quality Liquid Assets was postponed by four years. The rational given was that with macro-economic conditions as they are, it makes more sense for banks to be loaning money out and earning profits in the process rather than just focus on building up very low asset earning capital. What is disturbing to me is that it is yet another chapter where banks are more effective negotiators than those that regulate those banks.

One of the hallmarks of traditional, pre-Basel days was that virtually any asset, no matter how illiquid and speculative, could be counted for capital in making calculations. Basel III greatly limits the types of assets that favors cash, treasury bills, and similar instruments, and completely disqualifying most types of debt instruments. As a result, many domestic banks have greatly strengthened their capital levels, and reduced debt within their capital structures. The “tweaked” Basel III liquidity rules also will allow common stock holdings and AAA rated, mortgage backed securities to count as up to 15% of capital. One might think back upon AAA rated mortgage debt as one of the drivers of last decade's banking crisis. I thought I would take a look a look at a variety of domestic banks from a capitalization perspective.

The largest domestic bank, JPMorgan (NYSE: JPM), has long boasted of its “fortress balance sheet,” and while not the strongest bank in terms of capital, it is strong enough. It seamlessly absorbed the over $6 billion London Whale trading scandal, and had been approved by regulators last winter to pay class leading dividends and enormous share buybacks with what the Bank and regulators viewed as excess capital. Its Tier One capital under Basel III rules as of the close of the third quarter stood at 8.4%, up from 7.7% the year earlier. Note that after the London Whale story broke, JPMorgan suspended its share buybacks for about seven months, or until November of last year.

JPMorgan is on pace to earn about $20 billion this year, and in the absence of share buybacks, has been able to put about $8 billion into its capital “bank” even after paying the $1.20 annual dividend on its 3.8 billion shares outstanding. I fully expect regulators to approve virtually unlimited share buybacks by the second quarter of this year.

Bank of America (NYSE: BAC), the second largest bank, is also well capitalized from a regulatory perspective, with a Basel III ratio of 8.5% as of September 30th, 2012. I do not believe, as this bank jumps from one multi-billion dollar fine to another, this bank is suitable for anyone but the most risk tolerant of investors. Most recently it agreed to a $10.3 billion payment to government agencies on account of soured loans from 2000 to 2008 that were included in securities purchased by those agencies. That payment announcement came along with a separate agreement of Bank of America and nine other big banks to commit to a combined $8.5 billion over robo signing and other inappropriate foreclosure practices. These came just a few months after a $2.4 billion settlement of securities fraud in connection with Bank of America's purchase of Merrill Lynch.

Bank of America may turn a profit in the fourth quarter if its debt valuation adjustments are enough to overcome the fines. But none of these things have anything to do with Bank of America's core, ongoing business. Until all these one-time charges are cleared away, and I don't know when that will be, Bank of America is not for me.

America's third largest bank by assets, Citigroup (NYSE: C), actually does have more of a “fortress balance sheet” than does JPMorgan. Since Citigroup already complies with all Basel III standards, including the liquidity ratio, it stands to benefit the most by having up to $50 billion of cash freed to invest as it chooses. At the close of the third quarter, its Basel III ratio was 8.6%, and given that it has been restricted by the Federal Reserve from paying anything more than a nominal dividend or buying back shares, virtually all of its $12 billion or so of profit this year has been flowing right down to capital. New management are career bankers, a first for Citigroup in a generation, and I believe after another quarter or two of decent performance, I might be able to recommend Citigroup, which is still only selling for about 7% of its price ten years ago.

Of course, capitalization has little to do with profitability. After all, as banks were raking in profits in 2006 and 2007, their capital levels were about half what they are today. Smaller banks typically do not report their Basel III ratios. But among the best capitalized banks of any size is Cincinnati's First Financial Bancorp (NASDAQ: FFBC).  At the close of the third quarter, its Tier One capital level was 17%, nearly three times the 6% that is the threshold in this country of being considered “well capitalized.” But with so much of its money devoted to capital, it seems this bank does not pay that much attention to profitability. Earnings have slumped and analysts see earnings decreasing an average of 4% annually over the next four years. The bank's net interest margin is on a sharp downward curve, down 28 basis points in the year leading up September 30, 2012.

Management at First Financial plans to return 60% to 80% of its profits to shareholders going forward instead of reinvesting money in its loan portfolio. Despite the company's current generous dividend of 7.76%, I would avoid this well capitalized bank.

StockCroc1 has no position in any stocks mentioned. The Motley Fool owns shares of Bank of America, Citigroup Inc , and JPMorgan Chase & Co.. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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