The Wall Street Journal-20080123-Bank Shares Get a Reprieve But May Not Be in the Clear
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For weeks, bargain hunters have screamed that beaten-down banks were a buy. Shares in many, including big names like Wachovia, had nearly halved amid worries about their holdings of securities linked to mortgages.
The Federal Reserve's cut of three-quarters of a percentage point in its short-term interest-rate target -- to 3.5% -- makes the value argument more compelling.
Cheaper money will help banks repair their balance sheets and increase their earnings. Investors agreed, sending the Dow Jones Wilshire Banking Index up 3% yesterday. "Buy select bank stocks now," Raymond James & Associates analyst Anthony Polini said in a research note yesterday, adding that the "the best time to invest in the sector is usually during the back half of an economic downturn."
In his bullish pronouncement, Mr. Polini raised the main question for investors: Are the tough times nearly over, or has the pain just begun? If the recession that investors expect is mild, then banks are a buy. If it is deep -- and the Fed's action gives pause -- banks could have further to fall, or at least won't recover anytime soon.
The Fed's tonic hasn't worked so far. Before the latest move, the Fed chopped rates by one percentage point -- and those reductions didn't appear to have a big immediate impact on bank lending. "It's not clear that this cut will have much of a stimulus, given that the previous cuts didn't have a significant effect," says Joseph Mason, a professor at Drexel University in Philadelphia.
Of the many worries still facing banks, the biggest is that they will likely have to set aside more money than expected for soured loans on autos and credit cards. These loan-loss provisions -- which result in a charge against profit -- soared in the fourth quarter, and this expense could be higher than bank executives are forecasting.
"Banks are in complete denial about the losses that are coming," says Paul Miller, banks analyst at Friedman, Billings, Ramsey & Co. Mr. Miller estimates that large U.S. banks could book $100 billion to $120 billion in provisions this year and next to ensure that their loan-loss reserves are strong enough, with the bulk of that expense occurring this year.
Bank regulators also see a need for banks to increase reserves. Robert Storch, the Federal Deposit Insurance Corp.'s chief accountant, says that since banks are finding it harder right now to collect on their loans, their reserves should rise from present levels, which are low by historical standards. "Allowance levels, as a percentage of loans, should be increasing," he says.
Questions also exist over whether banks have taken big enough write- offs to account for securities they hold that are linked to subprime mortgages, particularly collateralized debt obligations. Banks and brokers have written down more than $100 billion in these securities, but given how murky the pricing of these securities is, it is hard to say if there will be more losses. Either way, investors remain suspicious.
When Bank of America announced earnings yesterday, analysts questioned its $5.3 billion in write-downs in the fourth quarter, saying its competitors appear to put lower values on similar securities.
On the bank's earnings call, executives said the valuations were based on models that tried to forecast their value based on the cash they would kick off as well as the underlying assets. "We have obviously tried our very best to look at others and see their markdowns, and it gets real hard, because the paper is just different," the bank's chief executive, Kenneth Lewis, said.
Even bigger problems could loom at Fannie Mae and Freddie Mac, the government-sponsored entities that provide support to the housing market through their purchases of billions of dollars of mortgages. Credit Suisse analyst Moshe Orenbuch said in a research note yesterday that Freddie Mac could take an $8 billion to $11 billion write-down on $105 billion of AAA-rated securities backed with subprime mortgages. That would amount to a 30% to 40% hit to Freddie's book value of $25.8 billion at the end of the third quarter, which could limit its ability to buy mortgages. Freddie Mac spokeswoman Sharon McHale said the company isn't commenting on the Credit Suisse report.
The idea that further hits to book value are still possible and that book value has become a moving target for some financial firms is also weighing on their stocks. "There has been a decline in confidence in the information that we've been given and that investors have been basing their decisions on," says Ed Yardeni, president of Yardeni Research Inc.
The wariness regarding book values comes even as prices as a multiple of this measure flash a strong buy signal. The 10 largest U.S banks by assets are trading at prices equal to about 1.2 times book value, according to Raymond James. Typically, banks trade at about two times book value.
Moves to raise new capital at many banks, and the dilution this will cause existing shareholders, also make it difficult to get a handle on book values.
