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Fed is Bearish on Banks
Until today I thought Meredith Whitney of Oppenheimer was the most negative observer of banks. That was, until I read the transcript of federal reserve Vice Chairman Donald Kohn's report to the Senate committee on Banking , Housing and urban Affairs. Kohn was there to report on the health of the industry since it falls under the fed's responsibilities to oversee the United sates banking system They also have primary supervisory responsibility over any state banks that choose to join the Federal Reserve system, that is to say, most of them.
According to the Vice Chairman, conditions are not so good for the banking industry. Led by credit losses in residential real estate portfolios and sharp markdowns in securitized loan products, the banking industry suffered losses of $8 billion in the fourth quarter of 2007. Interestingly, the 50 largest banks lost a total of $9 billion. This would seem to underpin my theory that the smaller banks are not quite as bad as their more free wheeling cousins in the big cities. In the first quarter the industry was profitable earning a total of $10 billion. Although the largest 50 contributed slightly over half of the earnings, seven of them continued to struggle and reported large losses. Again, it would seem that the larger banks that ventured into sophisticated loan and investment products suffered far more than small town banks in the quarter. Indeed Kohn testified that the larger institutions continue to have problems with loan portfolios, especially real estate development loans and home equity lines of credit. As a result of this continued weakness, non performing assets for US banks better than doubled in the quarter to $81 billion. This is the highest level of troubled assets since 2002. Loan loss provisions jumped in the quarter as well to $32 billion while loan charges offs totaled $14 billion.
Kohn also stated that the industry will probably have to continue raising capital to bolster beleaguered balance sheets. So far in 2008 Bank holding companies have raised over $80 billion of new capital. Some of this, Kohn admitted, was at the urging of banking supervisors and regulators. He pointed out the the growth in nonperforming assets was far outpacing the growth of reserves to protect against those losses. Combined with what the Fed Vice Chairman expects to be a very weak earnings environment for banks, future dividend cuts and capital infusions will be needed. In his words, the Fed is urging bank holding companies to bolster their financial positions.
State banks were in much better shape than their larger brethren. The state banks reported net earrings of about $3.7 billion in the first quarter and had a return on assets of about 1%. 98% of all state banks had risk based capital ratios that met or exceeded the regulatory definition of well capitalized. However, they did escape the troubled real estate markets entirely. Non performing asset ratios for the group better than doubled in the quarter to reach the highest level since 1993/ Loan loss provisions climbed as well and are now at 1.14% of average loans at state banks. The losses are primarily the result of the weak real estate markets across the United States.
Vice Chairman Kohn's outlook was less than rosy for the banking industry going forward. He expects continued declines in the real estate markets to continue to cause growing loan losses. He further warns that if the economy continues to weaken the losses could spread to credit card and consumer lending. He warned Senators that if liquidity and capital market conditions do not improve the number of banks that do not meet satisfactory capital ratios will increase from the low levels of the past few years.
He also discussed what the fed was doing to improve supervisory procedures over the nations banking system. This is a lot like locking the door behind the burglar in my opinion. What he did do, however, was set the ground work for additional regulations for the banking system. The impact of new regulations on the industry will be interesting to observe ion the months ahead. If we had enforced the regulations on the books and the fed had done its job, I doubt we would have gotten this deep into a financial crisis. I have yet to see an instance where increased regulation increased profits for any industry.
Where does this leave us? It is simple really. For right now avoid bank stocks. They have too many issues still in front of them. There will be further losses and their balance sheets are still weak. Many of them will have to raise capital, diluting the equity of existing shareholders. The bargains that do emerge in the banking industry will far away from Wall Street and outside the beltway. The smaller banks will have problems with real estate loans but it is much easier to recover loan losses form real property than an alphabet soup of securitized paper. Small banks with high capital ratios, high equity to asset ratios and adequate loan loss provisions can be profit machines. We are starting to get an opportunity to buy these at less than tangible book value. For patient investors, this will be better than the internet boom with a fraction of the risk!
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