Banks: Winners and Losers

Overall, we continue to maintain a negative outlook on both U.S. and non-U.S. Banks in the near-to-medium term.

The new Financial Stability plan announced by the Treasury Secretary Tim Geithner fell short on the details and we think that the benefits, if any, will take a long time to come by. While the earlier programs launched by the government have helped alleviate the capital and funding concerns to a great extent, the efforts have not succeeded in restoring the lending activity at banks.

It remains to be seen whether these steps and others like them in other countries will be sufficient to restore confidence in the financial system and increase lending.

In the meantime, lower lending activity will continue to hurt the margins though the low interest rate environment should be beneficial to the banks with a liability sensitive balance sheet.

It still remains a bit too early to begin building a position in bank stocks. We have yet to see any positive momentum from the initiatives so far as shareholders appear to be getting more dilution rather than less. We anticipate further consolidation in the banking space, as the weaker players fail and the stronger players seek to build up their positions, and may be assisted by the regulators in doing so.

Therefore, we suggest investors wait for signs of stabilization in the credit and stock markets. At that point, we suggest interested investors build small positions using dollar cost averaging.

U.S. Winners and Losers

As many of the bigger lending institutions continue work through their issues once again it should be the smaller regional players with local connections and the ability to view opportunities within their own markets that will first benefit from economic growth. In addition, we would expect to see a reemergence of the consolidation theme that ran at a frenetic pace during the 1990s over the next couple of years, albeit as a potentially slower pace.

We like the banks which have:

1. Solid capital levels (more so the Tangible Common Equity level)
2. Less exposure to housing (and or did not diluted their reasonable credit standards) and other related risky assets than their peers
3. Derive a significant portion of their revenues from non-interest income (not loan-based)

Among, the bigger banks, we expect Goldman Sachs Group (GS - Analyst Report), JPMorgan Chase (JPM - Analyst Report) and Morgan Stanley (MS - Snapshot Report) to emerge as winners.

Out of the banks that we cover, we like WestAmerica Bancorp (WABC - Analyst Report), Commerce Bancshares (CBSH - Analyst Report), Hudson City Bancorp (HCBK - Analyst Report), BOK Financial Corporation (BOKF - Analyst Report), and Texas Capital Bancshares (TCBI - Analyst Report).

At this time, we advise the investors totally avoid the bigger zombie banks, which are perfect candidates for capital infusion by the government after the stress tests, like Bank of America (BAC - Analyst Report), Citigroup (C - Analyst Report), U.S. Bancorp (USB - Analyst Report) and PNC Financial Services Group (PNC - Snapshot Report).

Non-U.S. Winners and Losers

As to non-US banks, we believe that banks in stable emerging economies, such as Chile, Brazil or India, may be more attractive investments, similar to what we expect for certain regional banks in the US. To be sure, banks in emerging economies will face asset quality issues; however, they are not confronted with other significant problems that many of the larger banks in Europe and the United Kingdom are, such as toxic securities, dilution from being forced to raise additional capital, and dividend cuts/omissions.

Moreover, they generally tend to be well capitalized, aren’t as heavily exposed to the property markets, and have significant and generally growing sources of noninterest income.

One caveat, investment in non-US ADR bank stocks entails foreign currency risk. Currently, the USdollar is appreciating against many foreign currencies, which tends to depress US$ share performance. On the other hand, when this turns and the US$ starts falling against other foreign currencies, this will accelerate gains in US dollar.

Investors may wish to look at HDFC Bank Limited (HDB - Analyst Report), one of the largest banks in India; Banco Itau Holding Financeira S.A. (ITU) in Brazil, the largest bank in Brazil following the February 2009 merger of Uniao de Bancos Brasileiros S.A. and Banco Itau Holding Financeira S.A. (or Itau); or Banco Santander-Chile (SAN - Snapshot Report), the largest private bank in Chile.

Topics For Consideration

U.S. Banks To See More Asset Deterioration

For the last few quarters, banks have mainly suffered due to the losses in the mortgages and CRE (residential construction loans). We are hopeful about the Obama’s "Homeowner" plan, but do not expect the housing markets to turn around any time soon and anticipate continued losses in the housing and related portfolios. Further, deterioration in other commercial real estate loans has started of late and the downturn in this class is also likely to be very challenging.

With the deterioration in the overall economic environment and rising job losses, we anticipate the losses will increase in all the other asset classes as well, especially in the consumer related loans. (It was recently reported that U.S. credit card delinquencies rose to a record high in January. They will likely rise further).

We also expect the deterioration in asset quality to continue at least through the end of 2009. Further, the banks will also continue to take mark-downs in the investment portfolios, further hurting the bottom-line.

We continue to remain a bit concerned with the lack of lending the banks. Not loans that may be placed through the Government Sponsored Enterprises, but rather those that are made by banks. A number of mortgage consolidator websites show what could appear to be non-realistic points and fee structures. While rate including fees and points are at historic low, what some may deem, "The cost of doing business," many others could deem "vulture pricing" or an attempt not do lend. Until this current practice is rectified, the positives from the stimulus program may not gain all the traction possible.

Foreign Banks Face A Daunting Outlook

Many countries have already adopted recapitalization plans.

For example, the British government already purchased large stakes in Lloyds Banking Group PLC (LYG - Analyst Report) and Royal Bank of Scotland Group (RBS - Analyst Report). Britain also completely nationalized other banks, such as Northern Rock.

When these efforts failed to stabilize the credit markets, an Asset Protection Scheme (APS) was adopted. Under this plan, the government insures the bank against losses on its most toxic assets (e.g., mortgage-backed securities and property loans) for more in return for a small fee and an obligation by the bank to increase lending to consumers and businesses. The bank absorbs the first 10% of the losses, with the British government assuming responsibility for the remaining 90%.

Though Britain and many other countries are trying to restore confidence, it is uncertain as to whether the current measures will be enough.

Consumer job losses and sluggish business conditions are increasing worldwide, which will tend to dampen demand for credit, even assuming banks are capable of lending more. Moreover, these factors will also hurt asset quality and increase losses on the existing "good" loan portfolios, even apart from considerations of toxic assets. Combined with top line pressure due to weakening economic conditions, non-U.S. banks face a daunting outlook.

Bank Nationalization

There is a lot of confusion about what would classify as "Nationalization" as evidenced by the very divergent opinions on the issue.

Some experts view any government ownership as a form of nationalization. Others feel that government ownership above 51% would be termed so. Technically, if the government owns 80% or more of a company’s shares, then accounting rules require the company to be put on the government’s balance sheet. (This is why the U.S. government decided to take control of 79.9% of the shares in Fannie and Freddie).

Both Treasury Secretary Geithner and Fed Chairman Ben Bernanke have spoken against nationalization, but the fact is that the U.S. government already has a substantial stake in the financial system of the country. With the latest round of bailouts, U.S. taxpayers will own about 78% equity in AIG and 36% in Citigroup. Instead of these piecemeal efforts at the banks, we think it would make perfect sense for the government to take control of such banks for a short period of time, and then split them and sell them to private parties or even relist them through initial public offerings.

Further, we suspect that the government will end acquiring substantial stake in all banks required to raise additional capital after stress tests are applied. This will be a necessity as these "losers" will find extreme difficulty with accessing private capital. As of now, stress tests are mandatory only for the large banks but may be expanded later to cover other banks as well.

In any case, whether it is nationalization or substantial ownership by a government, the investors of such banks will suffer badly or be wiped out. (This is what happened with Northern Rock shareholders.) Nationalization has been around for many years. In the U.S, nationalization was used effectively by the FDIC to take over 16 banks this year so far. Any government assistance accepted is a nationalization of the entity. While the Resolution Trust Corporation (RTC) did work to digest the volumes of assets seized in the last real estate bubble, it took multiple years to resolve, with benefit really only exhibited after the first 3 years and final resolution about 15 years later.

We think that it is important for all parties to remain as fiscally responsible as possible.

In the U.S., the current housing plan calls for mortgages to be reworked if the borrower misses a few payments or can demonstrate really need to intervention to remain in the home. This approach only rewards borrowers that have not been responsible. We believe that aid should be made available but not just given without any reasonable strings attached (accountability remains paramount).

If financial institutions were required to rework loans with reasonable terms and conditions(e.g. changing Alt-A and Option ARMs into more traditional loans), the results would be less foreclosures over the next several years from the pool of 10 million potential loans coming due.