Normally we hate analysts who recommend stocks at 100 and finally downgrade them at 15. So why should you listen to me when I tell you to avoid bank shares now? Even when the KBW Bank Index (BKX) has fallen from its February 2007 peak of 121.16 to 28.52 yesterday?
If you were investing during the early 1990s you did well if you bought the shares of strong banks in December 1990 near that market’s low and the shares of weak ones about two years later. The trouble this time is that… most banks are weak.
The big banks can look forward to more problems on many fronts. First, housing troubles are by no means done. There are plenty of adjustable rate mortgages out there whose borrowers are paying low, “teaser” rates and there will continue to be until 2011. Until that time we won’t know if these borrowers can handle a reset to market rates. That would be bad enough under current economic conditions, but for the moment the recession may be deepening. Many economists expect the “official” unemployment rate to peak at 9-10% in this cycle. That would translate to 15% or so of people willing to work full-time who can’t, once you factor in the “discouraged workers” who have quit looking, plus those who have involuntarily settled for part time work. So we can expect higher charge-offs on bank credit card portfolios and even on fixed rate mortgages formerly known as “prime.” Moreover, whatever is bad for first mortgages is worse for second mortgages such as home equity loans. Since the first mortgage holder normally gets first call on all proceeds from the sale of a home, if the first mortgage holder is not paid in full, the second mortgage holder gets… zero. And as for the once-lucrative business line of investment banking, well, don’t get me started.
So you want to look at regionals instead? Ha. Since many of them cannot compete with the majors on mortgages or credit cards, they are heavily exposed to… commercial real estate. Not good. According to research firm Reis, Inc., “rents fell in 43% of buildings of all types in the fourth quarter, up from an average of 25% in the first nine months of 2008,” Bloomberg reported today. That’s consistent with retailers’ woes: bankruptcies at Linens and Things and Mervyn’s, 500 stores to be closed at Starbucks (SBUX). As for mortgages secured by office buildings, Reis projects an 8.8% default rate. That’s ugly. After all, the great majority of banks have less than a dime of equity for every dollar of assets. If a business line such as commercial mortgages has a default rate that large, the capital devoted to that business line is dead money at best.
All of which brings me to my last point. Ongoing bad news implies more FDIC takeovers for small and midsize banks, more federal aid for banks that are too big to fail. If the FDIC takes over a bank, the shareholders lose everything. So far that has not happened to shareholders of big banks that have gotten TARP funds, but that situation could be too good to last. Sooner or later taxpayers may want something back from the banks in exchange for their TARP money, enough ownership to dilute if not wipe out the existing common. Either way, if you own bank shares there is a target painted on your back unless your institution has a well protected niche and excellent asset quality.