Rough ride ahead for holders of bank stock

You normally think of a bank president as a guy in a teak-paneled office, lighting a Cuban cigar with a $50 bill before his 3 o’clock tee time. These days, however, you’re more likely to see him tapping open his fourth pack of unfiltered cigarettes and popping Valium while watching the parking lot for agents from the Federal Deposit Insurance Corp.
And who could blame him? Bank stocks, by many measures, are very cheap indeed. If we accept the notion that it’s better to buy stocks when they are cheap, then shouldn’t we be buying bank stocks by the bushel? In a word, no. While there may be a few bank stocks worth buying now – and we’ll get to those in a bit – by and large, the banking sector has another act or two of its long tragedy to play out.
As you’ve probably noticed, things have gone horribly wrong in the banking system. Banks made a number of loans to borrowers with poor credit ratings, hoping that the higher mortgage rates they charged would offset the higher defaults that go hand-in-hand with subprime lending. They were mistaken.
Soaring loan defaults have forced banks to slash or cut dividends and write down the value of their loan portfolios.
Wall Street takes a dim view of these things, and bank stocks have been clobbered. Citigroup, the nation’s largest bank, has seen its stock tumble 68 percent the past 12 months. The Dow Jones U.S. select regional bank index has tumbled 48 percent. And Freddie Mac and Fannie Mae, which package mortgages and sell them to investors, have fallen 87 percent and 79 percent, respectively.
If you’ve been around long enough, you know that things go terribly wrong in the banking industry with depressing regularity. In the early 1990s, for example, the government bailed out the banking industry to the tune of more than $1 trillion because of ill-advised real estate loans. In the early 1980s, many banks took huge losses because of their ill-advised loans in the Texas and Oklahoma oil patch, as well as to Latin America.
And, unfortunately, bank stocks don’t usually form a neat bottom and then rebound smartly. They extend their suffering for a long period.
Initially, a troubled bank will disclose a few bad loans, and say that the worst is over. The next quarter, they will disclose a few more, adding that they have no plans to cut the dividend. Eventually, they cut the dividend. Afterward, perhaps, they issue more stock to raise capital. (Issuing more stock, by the way, is called “watering the stock” on Wall Street, because when you issue more shares, you dilute the value of existing shares.)
In the best case, the stock languishes for years until its numbers actually show some improvement. In the worst case, you get a notice from the FDIC, saying that your bank has a new name and, incidentally, your stock is worthless.
We’re still at the point where banks are largely denying their troubles, says David Ellison, manager of the FBR Large-Cap Financial Fund. “You can’t trust or believe anyone,” Ellison said.
For example, Bank of America paid a dividend of 64 cents per share in April: Multiply that by four and you get a $2.56 annual dividend payout per share. At the stock’s current price, that’s an 11.61 percent dividend yield – either astonishingly generous or ripe for a cut, depending on your point of view.
Bank of America CEO Ken Lewis, told the Los Angeles Times on Wednesday: “Given our view of things, we do not expect to cut the dividend, nor do we expect to have to raise capital.”
Ellison has doubts. “Their annual dividend payout is more than $10 billion. I think they could use that $10 billion right now,” he said.
Anton Schutz, manager of Burnham Financial Industries fund, says that a bank’s capital level – that is, the amount of money available through investors and retained earnings – is the most important consideration for investors now. “Capital is king,” he said. Banks that have enough capital will be able to make loans and investments. “Those who need capital are in a death spiral.”
Schutz has a few favorite well-capitalized banks, all of which his fund owns, incidentally. One is People’s United Financial (ticker: PBCT), a Connecticut bank; another is Investors Bancorp (ISBC), holding company for a New Jersey savings bank. But they’re admittedly rare.