Bank Stocks:  Has the towel been thrown in yet?
 

It’s probably not news to you that bank stocks are suffering a lot right now.  While investment banks and brokers led the financial sector down this ugly road in late 2007 and into the Bear Stearns collapse in March, regional banks have picked up the mantle since then.  This makes sense to the extent that securities held on the investment banks’ balance sheets must be marked to market, while banks’ loans are not.  This means that when the market gets concerned about the value of financial instruments, their prices drop immediately.  So, the big brokers started writing off billions last year.  Banks reserve for bad loans quarterly, and usually not until they’re reasonably sure that the loans will turn out to be bad.  Their loan loss reserves have been rising for 3 quarters now, on average, but chargeoffs haven’t really gotten ugly (yet?).

We believe we have entered the phase where the market starts to overshoot.  Surely we will see some banks fail in the next two years as chargeoffs continue to rise.  As George Donner wrote in our most recent quarterly newsletter, the two factors that will make or break individual banks will be the quality of their loan portfolios and how leveraged they are. 

Every cycle, the same thing happens to bank stocks.  First, a few “rogue” banks report troubles.  The market gets a little concerned, but quickly bets that these were isolated incidents, so all other banks rebound.  As it turns out, they were canaries in the coal mine.  Soon enough, more banks report problems.  Then the market paints all banks as troubled, so they all sell off.  After a quarter or two of sorting out, the market determines that some banks were fine after all, so investors flock to the “safe” banks and flee the troubled banks.  We were in that period until late May.  We have now officially entered the next phase, which is normally one of the last:  the throw-in-the-towel phase.  All banks are now selling off again.  The trajectory by which banks are plummeting in the last two weeks proves that we are in that phase.  Notice in the price charts that follow how a steady downward trend has turned into an asymptotic-shaped plunge.  These are not the worst-performing banks, by the way; they are just some of the biggest and most well-known regional banks.  As you can see, it doesn’t take a mathematician to extrapolate these trends to the point that the stocks will all be $0 within 3 more weeks.

Obviously, we believe that’s hyperbole.  This (with any luck) is the time where the bravest of brave value investors step in and catch the falling knife.  Someone needs to! 

We still believe there is phenomenal value in buying pretty much any bank stock right now, as long as they “make it out alive.”  One could argue that there are now 3 classes of bank stocks (instead of 2):  safe, dubious, and on life support.  The following banks would mostly fall in the dubious category:  they look like they’re nearing death, but their financials indicate otherwise.  The market now believes they will all be cutting their dividends and raising a boatload of new dilutive capital just to stay alive, but that might not actually come to fruition.  Banks in this category that don’t need to raise dilutive capital will turn out to be the biggest home runs once the recovery is underway.  Safe banks will obviously survive and recover, but won’t appreciate nearly as much as the dubious banks.  The biggest question for us to now contemplate is:  “when is the falling knife about to land on the ground?”  Only time will tell, but it sure is painful to not know the answer, and even more painful to add to bank stock positions while the knife is still falling.  What’s the antonym for “immediate gratification”?