Martin Hutchinson

[Editor's Note: This report on the U.S. banking sector is the latest installment of our "Outlook 2010" series, which chronicles the global-investing outlook for the New Year.]

In February 2009, I reviewed the operations of the 12 largest U.S. banks, and concluded most of them were sound.

In fact, I told Money Morning readers that the soundest were at that point excellent investment opportunities.

Judging by the performance of the Financial Select Sector SPDR (NYSE: XLF) Exchange-Traded Fund (ETF) since that time, one thing is clear: If you'd followed my advice you would have more than doubled your money.

Yes, the market's up, too, but not to that degree – so it's reasonable to say that I feel a quiet satisfaction over my early analysis of that troubled sector.

A Tough Act to Follow

Unfortunately, the U.S. banking-sector outlook for 2010 is not so rosy. Not only would you be buying at roughly double the price of February, but the sector's prospects are considerably grimmer than they were just a few months back.

I didn't get everything right in February. You can quibble only slightly with my ratings of banks: For instance, State Street Corp. (NYSE: STT) has been nothing like the solid player I predicted at the time, while Capital One Financial Corp. (NYSE: COF) has had less difficulty with its credit-card portfolio than I expected.

Overall, however, I was mostly right.

What I got wrong was my advice to readers to buy the shares in the top-quality banks: You actually would have fared better by investing in the lousy ones. Instead of the 100% you would have reaped by following my strategy, you could have made roughly 90% by now on Bank of America Corp. (NYSE: BAC), which I had dismissed as a "zombie," and about 210% on the "walking wounded" Capital One.

And if you'd waited until early March – when true despair ruled – you could have earned even more on the king of the "zombies:" Citigroup Inc. (NYSE: C).

Bad banks turned out to be the better investment than good banks for two reasons:

First, the government has intervened heavily in the banking sector, even since February. The "stress tests" were carefully designed so that everybody would pass, while the public investment in Citigroup was converted from preferred stock into equity on what looked like very favorable terms. Little or nothing has been done to break up the largest banks that had caused the problem; indeed, the only sanction on them has been for a "Pay Czar" to step in and limit the pay of their 25 top executives. Conversely, the good banks like U.S. Bancorp (NYSE: USB) and BB&T Corp (NYSE: BBT) were forced by the threat of state intervention to raise new equity to repay TARP (Troubled Asset Relief Program) money, and to cut their dividends, neither of them things they would have done in a free market.

And second, the other factor helping banks that I did not expect in February was the continuation of very low interest rates and the ongoing federal "stimulus." The U.S. Federal Reserve has purchased $2 trillion of U.S. Treasuries, mortgage bonds and agency bonds.

The Obama administration has continued its initiatives, too, such as the $8,000 tax subsidy to first-time homebuyers. This has helped bad banks more than good banks, because the housing-loan and mortgage-bond "books" of the bad banks were in far worse shape.

Protect Your Retirement with This Stock Market Crash "Insurance"

However, it has enabled all banks to make money simply by borrowing short-term money at a cost close to zero and lending it out to consumers and business at rates often in double digits.

The biggest beneficiary has been Goldman Sachs Group Inc. (NYSE: GS), which has enjoyed a trading bonanza, and which is now intending to pay out record bonuses on the basis of profits made using cheap, taxpayer-provided capital.

No Room for a New Year Encore?

Going forward into 2010, these factors stop being so positive.

First, it's most unlikely that the Fed will keep interest rates at such low levels in 2010. Commodity and oil prices have soared during 2009 because of the low interest rates, and at some point these escalating prices will translate into real inflationary pressures – even down to the consumer level.

When this happens, interest rates will have to go up. That will have three effects on bank profits – all of them bad.

• First it will reduce the huge trading profits that the likes of Goldman Sachs, Citigroup and Bank of America (which owns Merrill Lynch) have been making.
• Second, it will reduce the profitability of borrowing short-term and lending longer-term – indeed the banks that have invested in bonds with the interest rates un-hedged will even incur capital losses.
• Third, and last, the higher interest rates will tend to reduce the prices of assets such as houses and commercial real estate, thus causing larger bad debts.

The government's stress test earlier this year was based on a "worst case" U.S. economic scenario of 10.5% unemployment in 2010 and a 29% decline in U.S. house prices from the beginning of 2009.

Housing prices are now showing signs of having bottomed out only about 8%-10% below their December 2008 level. That's good.

However, the U.S. unemployment rate in October rose by 0.4% to reach 10.2%, and there must be a substantial chance in the new year that the U.S. jobless rate will blow through both the stress test's hypothetical level of 10.5% and the November 1982 postwar record of 10.8%. Combine that with a possible further decline in home prices if interest rates rise, and investors could be looking at some real trouble for the balance sheets of consumer-oriented banking institutions.

Since unemployment has never risen above 10.8% in the postwar period (and its duration above 10% was only 10 months in the rough 1982-83 downturn) the U.S. consumer-credit system is not "stress-tested" for such high unemployment rates.

Losses could be huge.

Of course, the government will very likely bail out the banks again if they get in more trouble. However, shareholders would probably be pretty badly penalized in that event, since politicians would likely conclude that investors should bear more of the cost for zapping taxpayers twice in two years.

That brings me to the other possibility, of punitive legislation against the banks – or some kind of "insurance premium" on those deemed "too big to fail." I'm talking about premiums in addition to those that banks already pay to the Federal Deposit Insurance Corp. (FDIC).

There is considerable political momentum behind this: The news of the record Goldman Sachs bonuses and soaring bank remuneration – coming at a time when the Fed is running policies specially designed for U.S. financial institutions to repair their capital and resume ordinary lending – is pretty compelling. It's not as if the banks were increasing their lending with the money they are being given; bank loans are currently running $600 billion below year-ago levels even as banks have nearly $2 trillion in excess reserves with the Fed.

Personally I would favor a "Tobin tax," a small tax on each transaction in bond, stock commodity and foreign-exchange markets. This would need to be imposed by global agreement, but could be levied on a country-by-country basis (you don't want to give global institutions a separate source of revenue, heaven forbid!).

Tobin taxes would fall most heavily on the very big conventional banks, as well as on the trading-oriented investment banks. They would hit especially hard the "fast-trading" business initiatives, in which investment banks profit from their inside knowledge of money flows.

That's all to the good; the "fast trading" business – and much of trading in general – appears to me to be pure rent extraction in which traders make money without providing anything of value to others. As a veteran banker myself, I can say with certainty that this is not true of most traditional banking and investment banking business, however.

Whatever tax the politicians decide to go with would strike both directly and deeply at bank profitability. If designed badly, this tax could also hurt the relatively innocent regional banks. There is also new talk of breaking up the biggest banks to stop them being "too big to fail" – again probably bad news for shareholders in the short-term.

With markets, loan losses and the government all likely to hurt banks in 2010 – especially in the year's second half – banks are not a savvy investment play right now.

However, there may come a period – perhaps in late spring – at which the overall stock market sees all the problems and again fails to distinguish properly between the badly run or scamming behemoths, and the valuable and well-run regional franchises.

At that point, selected banks will again be a "Buy."

Perhaps – as we saw last February – it will even once again be possible to double your money.

After all, risk does have its advantages!

[Editor's Note: Money Morning's "Outlook 2010" series has already provided readers with a forecast for the U.S. economy in the New Year. Watch for future installments addressing the economic outlook for oil prices, the high-tech sector, retailing, housing, foreign investments and other key topics.]

News and Related Story Links:

• Analysis of the U.S. Banking Sector (Part I of II):
  The Top 12 U.S. Banks: From Zombies to Hidden Gems.
• Analysis of the U.S. Banking Sector (Part II of II):
  Fifth Third – A Medium-Sized "Zombie" Bank.
• Money Morning Analysis of the U.S. Banking Sector:
  Money Morning's Bank Stress Test Says These Three Banks Are the Strongest.
• Money Morning News Analysis:
  Bank Stress Tests: The Results Are in; Now What?
• Wikipedia:
  Tobin Tax.
• Money Morning News Analysis:
  BB&T, Capital One, U.S. Bancorp and KeyCorp Planning Stock Sales to Raise Capital, Repay TARP.
• FDIC.gov:
  Official Web Site.
• Money Morning News:
  Obama Administration Wants New "Pay Czar" and Shareholder Vote to Reign in Executive Compensation.
• Wikipedia:
  Too Big to Fail.
• Money Morning Special Report: First Anniversary of the Financial Crisis:
  Wall Street Back to Business as Obama's Regulatory Overhaul Loses Momentum.
• Money Morning Market Commentary:
  High Frequency Trading: Wall Street's New Rent-Seeking Trick.