The Market Now Believes All Banks Are The Same

For months I have been in the camp of investors arguing that there are distinctions between U.S. banks. The comparisons have been made for a long time. JPMorgan Chase (JPM) is better than Citigroup (C). Wells Fargo (WFC) is better than Wachovia. The market seemed to agree with this premise until recently, and Tuesday’s market action in the banking sector was startling. Once again we have fierce and indiscriminate selling of all banks.

The drops in these stocks in recent days signals than many market players believe that all of these banks are in serious trouble, regardless of whether they have or have not done things such as loaned to sub-prime borrowers, accumulated lots of structured products on their balance sheets, maintained strong underwriting standards, or focused more on businesses rather than consumers.

The fear now is that the stronger banks who bought up the troubled institutions for pennies on the dollar actually did not get a good deal. Instead, the bad assets they took on will cripple them. The government will be forced to bail them out, common stock dividends will be eliminated, equity holders diluted, share price values decimated, and the companies eventually nationalized.

While this may be true in certain instances, I still do not believe that every large U.S. bank is on the brink. The market though, disagrees right now. After all, people thought State Street (STT) was safe because its main business was not lending, but rather back office and custodian services. And yet somehow they have managed to amass an $80 billion investment portfolio with $6 billion of unrealized mark-to-market losses so far. Maybe it isn’t safer.

Fourth quarter earnings reports released in coming days and weeks will shed more light on whether banks that have been able to post relatively better financial results this far in the cycle can continue that trend. Maybe all of the number-crunching people like me have done in recent quarters, trying to identify the better banks, was a worthless endeavor. I sure hope not.

If last quarter marks the end of that relative out-performance, there might not be a single bank stock that qualifies as quality. That would be a sad day, but the market is losing patience and is spooked by that possibility, as Tuesday’s trading brought with it 20, 30, even 40 percent losses for some banks on relatively little or no news.

One of the better banks in the eyes of many, U.S. Bancorp (USB), released earnings today and recorded a fourth quarter profit of $330 million. The market has greeted the news by sending the stock down 12% today, bringing the year-to-date loss to -46 percent. The culprits appear to be worries over increasing credit losses and the possibility of a dividend cut.

These two issues are interesting because many of us believe that increasing credit losses and dividend cuts are to be expected. As the economy worsens, credit losses rise and in order to cover those losses and reserve for future ones, earnings will drop below dividend rates and dividends will be cut. These things should be obvious by now.

For a company like U.S. Bancorp though, it appears manageable and investors should not own the stock just for the dividend. USB is an excellent franchise and the long-term earnings power of the company is what should drive the share price. As a shareholder, I don’t mind if USB has to cut or eliminate their dividend for a year or two in order to cover credit losses from loans made during the boom.

Looking at USB’s losses and reserves, I don’t see a reason to be panicky. Charged off loans in Q4 were $632 million. The company covered those, set aside another $635 million for future losses, and still earned a profit of $330 million for the quarter. Total allowance set aside for future credit losses sits at more than $3.6 billion. USB’s gross earnings (before credit losses) was $1.66 billion for Q4, so between that and the $3.6 billion already set aside, the bank has plenty of capital to cover increased losses throughout 2009.

While there are no banks, strong or weak, that are going to be able to avoid increased credit losses over the course of 2009, there are certainly banks that are better positioned to withstand the losses than others. Although the market is no longer giving them credit for being one of the stronger institutions, companies like U.S. Bancorp are the favorites to survive the current economic downturn and be stronger on the other side of it with fewer competitors. Investors looking at bank stocks need to take that kind of longer term view. If you are looking to make a killing over the next three or six months, bank stocks are not the place to look.

Full Disclosure: Peridot was long USB at the time of writing, but positions may change at any time.

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2 Thoughts on “The Market Now Believes All Banks Are The Same

  1. Hondo on March 4, 2009 at 11:03 PM said:

    Perhaps Chad’s position has changed from this 1/21/09 posting, but USB cut its dividend on 3/4/09. Why would a bank with “plenty of capital” (Chad’s words above) do that? On their conference call about the action, they specifically stated it wasn’t primarily driven by a desire to repay TARP capital.

  2. Chad Brand on March 5, 2009 at 8:53 AM said:


    Banks aren’t earning their dividends right now, as credit costs are soaring and reserves need to be built to cover them. No bank is going to keep paying a dividend it isn’t earning.

    The second reason strong banks like JPM, PNC, and USB are cutting their dividends is because the government and investors are now focusing on tangible common equity ratios. The Tier 1 capital ratio has been the desired metric because it does not treat all assets and liabilities as having the same risk profile, but since common equity is now a focus, banks are going to increase common equity, hence the dividend cut.

    My position on the banks has not changed. They are all getting hit hard, but the strongest ones will survive and have higher market share when the economy improves. Consider JPM and PNC, both of which are still profitable even as GDP is falling 6% per quarter. If that does not signal a strong bank, I don’t know what would.

    As a result, I continue to avoid the bad banks and invest in the strongest ones at discount prices. It will take patience for this trade to pay off, but I’m a long term guy, so that’s fine with me.

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