Why wait for the U.S. Treasury Department's bank stress test when Money Morning can highlight the four secrets that will let you separate the winners from the losers in the U.S. banking system?
Call it the "Money Morning Bank Stress Test."
Back in February, I looked at the Top 12 U.S. banks, to determine whether it was really necessary – as U.S. Treasury Secretary Timothy Geithner was proposing at the time – to devote the enormous sum of $1.5 trillion of our money to bail them out. I came to the conclusion that such a huge bailout was unnecessary, and that only a few of the Top 12 banks seemed in any danger of collapse. Fortunately, policymakers and the market have now come to agree with me.
With banks' first-quarter figures now out, it seems a good time to take another look. Since, at reader request, I had added Fifth Third Bancorp (Nasdaq: FITB) to the Top 12 (I have written on Goldman Sachs Group Inc. (NYSE: GS) and Morgan Stanley (NYSE: MS), now technically banks, separately), meaning that we now, here, have a "Top 13" list of banks – a bit smaller than the list of 19 the government has stress-tested.
[I'm aware of the hang-ups and superstitions involving the number "13." But I'll brave the bad luck, as I can't believe that number will stay at 13 for more than a few months; at the bottom end of the quality spectrum, there are clearly a few banks that need to be put out of their misery.]
All of the financial institutions discussed here have been subjected to Treasury Secretary Geithner's "bank stress tests" and we are told they have all passed, with one exception (more information is due to be released Monday). That is hardly compatible with the government stance – of just two months ago – that another $1.5 trillion would be needed. I would suggest that the truth is somewhere in between the two extremes: Most of these banks are in reasonable shape and can be expected to recover on their own, but a few need to be put out of their misery.
For the U.S. Treasury Department to buy up "toxic assets" in alliance with hedge funds seems a very bad idea; these banks have been managing their toxic assets themselves and know their portfolios best. Banks that have accumulated toxic-asset portfolios too large to manage, or that are managing them ineptly, should be put out of their misery – and not rewarded with asset purchases at inflated prices. Capital needs to be invested in the most-efficiently run venture, not the least-efficiently run institution.
There is lots of information – about both the potential bailout needs and possible investment bargains – that can be gleaned from the banks' first-quarter reports. But there are four key factors that investors can employ to separate the investment-worthy bank stocks from those that aren't.
These four Money Morning bank-stress-test secrets will lead investors to conclude:
- Banks that made profits in the very difficult fourth quarter of 2008 and first quarter of 2009 are probably in good shape, especially if their loan-loss provisions exceeded their charge-offs (the amount actually lost.)
- Banks that lost money in the fourth quarter and first quarter may or may not be in terminal trouble; it depends on the amount of those losses and whether the red ink is expected to continue to flow going forward.
- With the run-up in bank stocks in recent weeks, there's been an accompanying rise in the ratio of share price to book value (stock price per share/book value per share). If that ratio is still below 30% – even after the recent price increases – the market lacks confidence in the bank's ability to solve its own problems. Unfortunately, the market currently appears to be overly optimistic about some of the banks that still have considerable ongoing problems.
- Management's dividend policy is less of an indicator than it was just a few short months ago; several banks have sharply cut their dividends in order to repay the Troubled Assets Relief Program (TARP) capital they got in late 2008. Reasonably, profitable banks don't want the government meddling in their business or compensation structures
Using those four Money Morning bank-stress-test indicators, we can assess the viability of the leading U.S. banks. We can then divide them into four categories, from weakest to strongest (Zombies, Walking Wounded, Risky-but-Proud, and Hidden Gems). Here are the four categories, and how we defined them:
- Zombies: Institutions kept alive only by TARP funding. These subtract value from the economy and should be put out of their misery through controlled liquidation, with the healthy parts being salvaged.
- Walking Wounded: These may well need some moderate additional help, but are operating reasonably well on their own, right now. Even so, there is a caveat: Should there be an intensification of the current U.S. economic downturn, one or more of the "Walking Wounded" could be pushed into "Zombie" status – or even bankruptcy.
- Risky-but-Proud: These banks have relatively high risks, either because of some ill advised past acquisitions, or because of their business mix. Even so, the "Risky-but-Proud" banks are operating at full blast and can hold their heads high for their success in dealing with enormous difficulties.
- Hidden Gems: These banks have conquered 2008's difficulties, taken care of their bad-debt problems, and still managed to make a substantial profit. Short of a repeat of 1929-1933, they should continue to do so. Not all these "Gems" are still hidden, however, now that the market has experienced a substantial run-up from its bottom, with many bank stocks seeing even bigger gains.
Here are the Money Morning stress-test ratings of the 13 largest U.S. banks (by assets). The list that follows ignores foreign-owned banks, and also avoids Goldman Sachs and Morgan Stanley, for the reasons we cited earlier. We list the "Top 13" here in reverse order (smallest banks listed first), because the status of the biggest banks is much easier to determine after you've studied comparable regional banks, which have simpler businesses:
13. Fifth Third Bancorp (Nasdaq: FITB). Zombie: With $120 billion in assets, and having received a $3.4 billion TARP investment, this Cincinnati-based regional bank grew by buying other banks in the Midwest and Florida. A recent share price of $3.71 meant Fifth Third was trading at 28% of book value. It lost $1.2 billion in 2008 (even after goodwill write-offs), and has lost another $26 million in the first quarter of this year – a bad result, since the 2008 disaster and the TARP investment should have allowed it to mark down its bad assets, taking "everything but the kitchen sink" into the 2008 loss. Without further federal assistance, Fifth Third's survival as an independent entity would seem to be extremely doubtful; an orderly liquidation would seem the best alternative. Certainly it should not be subsidized further.
12. Regions Financial Corp. (NYSE: RF). Walking Wounded: With $146 billion in assets, and a $3.5 billion TARP investment, this Birmingham-based regional bank has operations primarily in the Southeast. A recent share price of $5.56 meant Regions Financial was trading at about 30% of book value. It has cut its dividend to a nominal 1 cent per share. It lost $5.6 billion in 2008, and its tangible net worth is only $10.5 billion. However, that loss was entirely an impairment of goodwill; on an operating basis, Regions made a profit of about $300 million. It notched a $77 million profit in the first quarter, although executives stated on the conference call that its Georgia and Florida markets were still a problem. Regions is a definite "Walking Wounded" bank, and is very close to "Zombie" status. However, it's likely to need only modest additional funding, and looks to be significantly stronger than Fifth Third.
11. BB&T Corp. (NYSE: BBT). Hidden Gem: With $152 billion in assets, and a $3.1 billion TARP investment, this Winston-Salem, N.C.-based regional bank has its primary operations in the Mid-Atlantic region. A recent share price of $23.42 meant that BB&T was trading at about 94% of book value. BB&T was profitable in each quarter of 2008 and in the first quarter of 2009, making $1.5 billion for all of last year and $271 million in first quarter of 2009. It maintained its dividend of 47 cents a share for first quarter of 2009, the only bank to maintain its full payout. The question, of course, it whether management will be tempted to follow fashion and cut the dividend next quarter; otherwise, it looks very solid.
10. Capital One Financial Corp. (NYSE: COF). Zombie (was Walking Wounded): Primarily a credit-card company with some banking operations it acquired, this McLean, Va.-based company has $161 billion in assets, and accepted a $3.6 billion TARP investment. Capital One looks to me like the credit-card-market equivalent of mortgage lender Countrywide Financial Corp. Capital One's recent share price of $18.97 meant that Capital One was trading at 28% of book value. It lost $1.4 billion in fourth quarter of 2008, and was just below breakeven for the full year, although it reported making $895 million from continuing operations. Capital One lost $112 million in first quarter of 2009, and cut its quarterly dividend from 37.5 cents per share to 5 cents a share. If credit card losses continue to deteriorate, as seems likely, Capital One is a "Zombie," and only a sharp improvement in the credit-card market can save it.
9. State Street Corp. (NYSE: STT). Hidden Gem: With $174 billion in assets, and a $2 billion TARP investment, this Boston-based bank is focused chiefly on serving institutional investors worldwide. Its recent share price of $37 meant that State Street was trading at 146% of book value. Its 2008 earnings per share (EPS) of $3.89 represented a year-over-year increase of 13%. First quarter net income down 16%, but State Street still earned $445 million. It pays a quarterly dividend of 24 cents per share. With a global business, conservative leverage and Boston management, State Street is a great risk. But it's somewhat of an unexciting investment currently as securities issues and trading volume have fallen.
8. SunTrust Banks Inc. (NYSE: STI). Walking Wounded (but in danger of Zombification): With $189 billion in assets, this Atlanta-based regional bank accepted a $4.9 billion TARP investment, and has operations in the Mid-Atlantic and Southeast regions, especially Florida. With a recent share of $15.96, SunTrust was trading at 31% of book value. It posted a fourth-quarter loss of $379 million, but its overall 2008 profit was $747 million. However, SunTrust posted a first quarter loss of $815 million, including $715 million of mortgage- and real-estate-loan losses. The bank reduced its quarterly dividend sharply to 10 cents per share in fourth quarter. SunTrust saw its financial position deteriorate in the first quarter, and is in severe danger of zombification, although there are now reasons to believe most of its problems may be out in the open.http://www.google.com/finance?q=bk
7. Bank of New York Mellon Corp. (NYSE: BK). Hidden Gem: With $237 billion in assets, and a $3 billion TARP investment this New York-based bank has its primary operations in New York and Pennsylvania, and has an institutional/corporate orientation. With its recent share price of $26.88, it is trading at 122% of book value. It reported 2008 net income of $1.39 billion, and first quarter profit of $322 million, after which the bank reduced its quarterly dividend from 24 cents to 9 cents a share. Looks solid to me.
6. U.S. Bancorp (NYSE: USB). Hidden Gem: It has $266 billion in assets, and a $6.6 billion TARP investment and is a regional bank headquartered in Minneapolis that operates primarily in the Midwest and Northwest. A recent share price $18.97 means it is trading at 176% of book value. It reported a 2008 profit of $2.94 billion, and a first quarter profit of $419 million. U.S. Bancorp cut its quarterly dividend from 42.5 cents per common share to 5 cents a share, as it wants to pay back its TARP investment. This bank is in good shape, but its capital base would become too thin if it repaid TARP; I'm not sure I want to pay 11-12 times earnings for this stock when the dividend's so low and the uncertainties are so high, as there's still some chance of dilution, should it raise capital.
5. PNC Financial Services Group (NYSE: PNC). Risky but Proud (but close to upgrading to Hidden Gem): With $291 billion in assets, and a $7.6 billion TARP investment, this Pittsburgh-based bank bought the slightly larger Cleveland-based National City Corp. in October. Its primary operations are in the Mid-Atlantic and Midwest regions. A recent share price of $43.22 meant it was trading at 104% of book value. PNC's net income was $882 million for 2008, and $460 million for first quarter of 2009. It cut is quarterly dividend from 66 cents per common share to 10 cents per common share. PNC appears to be handling its National City acquisition well, but remains concerned about possible deteriorations in its credit quality. Nevertheless, PNC's problems – particularly those derived from National City's Ohio base – are not hidden, and its continuing profitability means PNC is close to an upgrade.
4. Wells Fargo & Co. (NYSE: WFC). Risky but Proud (but close to upgrading to Hidden Gem): With $1,309 billion in assets, and a $25 billion TARP investment, this San Francisco-based bank went national with its acquisition of Wachovia Corp. With a recent share price of $21.40, this stock is trading at 123% of book value. Wells incurred a fourth-quarter loss of $2.55 billion, not including $11 billion net loss at Wachovia; full-year 2008 earnings were $2.84 billion, and first quarter 2009 earnings came in at $2.38 billion. The stock pays a quarterly dividend of 34 cents per share, but may cut the payout (though this has yet to be announced). Like PNC, Wells is fairly high risk because of the acquisition and Wachovia's own 2006 acquisition of the California mortgage bank Golden West Financial. But Wells, also like PNC, benefits here because most of its problems are in the open. Optimism may have pushed this stock up too high in the near-term, however.
3. Citigroup Inc. (NYSE: C). Zombie: With $1.945 trillion in assets and a $45 billion TARP investment, plus government guarantees on $301 billion of its assets, this is the big fish for federal regulators. I believe it should be liquidated, though maybe the regulators they want to practice on Fifth Third, first. A global financial conglomerate based in New York, Citi has been a serial flirter with bankruptcy over the last 30 years. A recent share price of $3.19 means the bank is trading at 25% of book value; it's the only bank stock down since my February report. Citi lost $18.7 billion in 2008. It theoretically made money in the first quarter of 2009, but lost it again because it had to reset the terms of some preferred shares issued the previous year, further diluting common shareholders. It reduced its dividend to a nominal 1 cent per share. At the annual stockholder's meeting, Citi Chairman Richard Parsons said that "shareholders want profits or flesh, either one." If I were a Citi shareholder, I'd want both.
2. JPMorgan Chase & Co. (NYSE: JPM). Risky but Proud (close to upgrading to Hidden Gem): With $2.175 trillion in assets, and a $25 billion TARP investment, this New York-based international bank has a large investment-banking operation and bought The Bear Stearns Cos., in March 2008 and the housing-lender Washington Mutual in September – both with federal help. With a recent share price of $33.38, JPMorgan was trading at 92% of net asset value. It had 2008 net income $5.6 billion, and made $2.1 billion in the first quarter of 2009. JPMorgan reduced its quarterly dividend of 38 cents per share to 20 cents in this year's first quarter. Again, very high-risk because of its acquisitions, JPMorgan nevertheless appears to be in excellent shape – and like PNC and Wells Fargo, may be overcoming the problems it does have.
1. Bank of America Corp. (NYSE: BAC). Zombie: With about $2.8 trillion in assets (including Merrill Lynch & Co., which was acquired after the 2008 year-end), and a $45 billion TARP investment (plus $118 billion in asset guarantees against Merrill Lynch assets), this Charlotte, N.C.-based retail bank is a nationwide player. It bought No. 1 housing lender Countrywide Financial Corp. and No. 3 investment bank Merrill Lynch in 2008. Its recent share price of $9.10 meant it was trading at 32% of book value. BofA reported a fourth-quarter net loss of $1.55 billion, plus the Merrill Lynch net loss of $15.3 billion. It reported a first-quarter profit of $2.8 billion after preferred share dividends, but that included $2.2 mark-to-market write-up of Merrill Lynch debt (the opposite of all those "mark-to-market" write-downs that banks are whining about). It reduced its quarterly dividend to a nominal 1cent per share. Judging by other banks' results, if Bank of America had made no acquisitions in 2008, it would be in solid shape today. However, excluding special items, it's barely ahead of break-even in the first quarter after a horrendous 2008, and seems decidedly accident-prone. As the revelations about former Treasury Secretary Hank Paulson strong-arming BofA Chief Executive Kenneth Lewis to push through the Merrill deal seem to show, the bank's management is pretty anti-shareholder, too.
There are two types of conclusions to be drawn from this analysis, public policy conclusions and investment conclusions.
On the public policy side, it is becoming even clearer that buying up bank "toxic assets" is a very expensive way to attack the problem. The government provides taxpayer subsidies both to hedge funds doing the buying and to banks doing the selling, most of which don't need the money. At the same time, for the "Zombies" like Fifth Third and Citigroup, taxpayers would have to buy a huge chunk of the balance sheet before the problem was solved.
Equally, there are some banks out there that are not going to recover on their own, and it's getting close to time for some "tough love." There's a public policy case for further subsidies to the borderline cases – Regions and maybe SunTrust – but there is no good case for further subsidies to Fifth Third and the egregious Citigroup, or to Bank of America. As for Capital One, if the credit card business recovers very quickly, it may survive on its own. But if the market doesn't improve, Capital One should be liquidated, since its business model is based on aggressive card marketing and controversial fee charging – practices which should both be discouraged in a well-run financial system.
For outside observers, the best sign that the crisis is really over will be when the Feds push one or other of the Zombies over the edge. That may not be for some months yet, however.
The investment picture for banks has deteriorated in three ways since my February report:
- First, some of the borderline cases, notably SunTrust and Capital One, have slid further towards Zombie status.
- Second, several banks that were paying juicy dividends have cut them sharply, in spite of continuing to earn enough to cover them. However, since many of the nation's bank management teams want to get out from under the TARP bonus restrictions, those cuts were decidedly anti-shareholder in nature.
- Third, stock prices have shot up – in several cases by more than 50% – even for doubtful survivors like Capital One. Investor sentiment has swung from deeply negative to rather positive on the U.S. banking system, while the sector's overall condition has somewhat deteriorated. Stock prices well above net asset value do not adequately account for the considerable continuing risks to the U.S. banking system, or of the feeble dividends that most banks currently pay.
Of the healthier banks, I like JPMorgan Chase, because it is still trading at less than book value, even though the investment banking part of its business is intrinsically unattractive. PNC, at just above book value, is also probably worth looking at; it appears to be well run. Finally, if BB&T avoids the dividend cut frenzy, and maintains its 47-cent dividend (the announcement will be made around May 24), its 8% yield makes it attractive.
News and Related Story Links:
Money Morning Investigative Report on the Bank Bailouts (Part VIII):
Obama Administration Must Revive "Shadow Financial System" to Revive U.S. Banks.
Money Morning News Analysis:
Controversial Stress Tests Reveal Only One Bank Needs Capital, but Worries Remain.
More than 100 funds want to buy toxic assets.
Troubled Asset Relief Program.
Money Morning Market Analysis:
The Top 12 U.S. Banks: From Zombies to Hidden Gems.
Money Morning News:
Bank of America's Lewis Says Paulson, Bernanke Forced Merrill Takeover.