It's Too Early To Invest in Banks

By DAN DORFMAN
February 15, 2008

If Jesse James and John Dillinger were around today, worried bank officials no doubt would plead with the robbers: "Please, not us, we're already writing down a boatload of bad assets."

The request would not be without merit. Reflecting a slew of questionable loans, the nation's largest banks and brokerages, among them Citibank, Bank of America, Merrill Lynch, and UBS, have been forced to write down more than $100 billion of bad assets, and the worst may be far from over on the banking front.

Not unexpectedly, bank stocks have taken a beating, tumbling an average 20.8% last year and declining about another 7.5% this year.

In response, a number of brokerage firms and research organizations — hoping for strong rebounds — are aggressively pushing the shares of many of the beaten-down big names, conspicuously Citigroup, JPMorgan Chase & Co., Bank of America, and Wells Fargo.

Some pros, though, question such pitches, arguing that while large-cap bank stocks may look cheap, those pushing them are ignoring the danger of more balance sheet chaos and even lower bank stock prices. In other words, they say, investors are being pitched damaged goods at too early a stage.

Some disturbing forecasts bear this out. Goldman Sachs, for example, pegs additional bank writedowns at $60 billion, and Oppenheimer & Co. is estimating $70 billion. Meanwhile, Bear Stearns figures total bank write-downs could run upwards of $175 billion, while banking bear Weiss Research in Jupiter, Fla., predicts a few hundred billion.

Who is right, or closest, is anybody's guess. Whatever the number, which everybody agrees will be gigantic, the ongoing and growing write-down threat raises serious doubt about the contention that the worst is over for the financial stocks and it's time for some lively buying of the big banks.

"Betting on bank stocks at this time is like betting that Mike Huckabee will be the Republican presidential nominee," money manager Arnold Silver of A. Silver Associates in Los Angeles quips. "It's a stupid bet because, in both cases, you're up against practically insurmountable odds."

A West Coast money manager who runs nearly $100 million of assets under the banner of San Francisco-based Gary Wollin & Co., Gary Wollin, also contends that it's too early to own bank stocks.

"Owning them now is like flying in stormy weather in a single-engine plane; it makes no sense," he says. "We're definitely in a recession and things could get much worse for the banks before they get better." Mr. Wollin says he has an uneasy feeling there are a lot more write-downs ahead. "But even if I'm wrong," he adds, "the banks could be dead money for the next two to three years."

A Morgan Stanley bank analyst, Betsy Graseck, argues that the banking group should be underweighted. She reasons that higher loan losses, reserve hikes, and an accelerating housing slump will drive down per-share earnings of the large-cap banks through 2009.

Pointing to deteriorating home values and a mild recession, she sees mounting losses in residential mortgage and construction, credit cards, auto, and commercial real estate. As such, she has boosted her banking reserve estimates to recession levels and has downgraded her ratings on some leading banks, among them Wells Fargo and Wachovia Corp.

She also advocates an underweighting in Citigroup, pointing out that, among other things, it has the largest industry exposure to subprime loans (13% of its loan book), as well as to collateralized debt obligations ($30 billion net of hedges), and the risk of further write-downs in its Japanese consumer finance business.

In making her case, Ms. Graseck also calls attention to the issuance of a recent senior loan officer survey that confirms a credit crunch is under way. She says it supports her underweight call on the banks, as loan growth should slow and loan losses rise. Banks, she points out, are tightening lending standards in every loan class, and in most cases they're already at or above prior recessionary peak levels of net tightening. Further, tighter lending standards, coupled with Morgan Stanley's outlook for a mild recession, suggest to the analyst that loan losses will peak above levels consistent with similar recessions.

"It's too early for bottom fishing in bank stocks," analyst Michael Larson of Weiss Research observes. Interest rate cuts will enable banks to generate more net interest income, he says, but the problem is that their challenges extend well beyond the already huge residential and mortgage problems. He points, in particular, to such concerns as the estimated $230 billion-plus of buyout and junk bond loans, and that "the credit explosion has gotten nutty."

Mr. Larson says he would sell such stocks as Citigroup, Bank of America, JPMorgan Chase, Citigroup, and Wells Fargo because of his firm belief that "there's still plenty more downside risk."

He figures the purging process — such as write-downs of bad debt, raising loss reserves, and rebuilding capital — has a ways to go yet; likewise, he says he thinks it will take at least several more quarters before bank stocks can reverse their downward trend. So for now at least, he says, "it should be hands off."

dandorfman@aol.com