Quarterly Newsletter April 3, 2017



The banking industry has a long and generally honorable history, and many good citizens have grown wealthy by investing in it.  But with the wrong bank, there are big risks.  Bank investing can be like taking a cruise.  Most of the time it’s smooth sailing, but if your timing is unlucky you may run into a typhoon, such as the one we experienced in the 2008-2009 financial crisis.  Here is a picture of what happened to mighty Bank of America, one of our nation’s largest.  Too big to fail?  Pity the poor shareholders.

During long periods of favorable business conditions, most banks appear similar to one another, quiet and prosperous, selling the same financial services.  Nothing would seem so easy, even boring, as owning bank stocks with their above-average dividends and steady growth.  The general stock market is known to have dramatic ups and downs more or less related to America’s economic cycles.  With banks, due to their financial leverage, these cycles are magnified to the point that in a severe downturn some institutions can face not merely depressed earnings, but actual insolvency.  Some bank names disappear forever as they undergo a forced marriage, at near-bankruptcy prices, to a stronger institution (examples: Provident Bancshares taken over by M&T Bank; National City by PNC; Wachovia by Wells Fargo).

In the months following a financial meltdown, excess and folly get squeezed out and the surviving banks gradually return to profitability.  After a while they start raising the dividend again, and continue this encouraging pattern until everyone has forgotten all about that spot of trouble they got into years ago.  Then another typhoon roars up and shareholders get soaked all over again.

What is intriguing to us as investors is that some banks are able to withstand these storms a lot better than others.  But it is difficult, maybe impossible, to measure the quality of a bank just by studying the financial statements.  Deposits, loans as a percent of assets, efficiency ratio, return on equity, recent growth rate, etc. are interesting figures, but they do not reveal whether it is a good (safe) bank – one that can “take a licking and keep on ticking.”  Even if you work at the bank, it can be very hard to tell.


Poor economic conditions (recession) will cause a bank, like any other business, to record disappointing earnings.  But actual bank failures usually result from bad loans:  The bank gets into a cash bind because they lent to weak borrowers who fail to pay the money back again.  In the peculiar language of bank accounting, loans are considered assets, since they are the means by which a bank earns interest income.  The challenge for investors is that a plump $200 million of loans on the balance sheet may be either “good” or “bad” loans, and they all look the same as long as there is no trouble.  But under duress this “asset” may not really be worth $200 million at all, or anything close to it.  It depends on how careful your loan officers have been in evaluating the credit of each borrower, and his ability and willingness to pay.  Merely looking at the “loans” figure doesn’t tell us that.  In boom times like the real estate speculation of 2005-2007 when “house-flipping” profits seemed so easy, the discipline may get sloppy, and that is how a bank can end up losing a boatload of money.

The crash of 2008-2009 was the worst financial panic since the Great Depression of the 1930s.  In earlier crises, bad loans resulted from speculation in farmland, or oil wells, retail malls, auto dealerships, etc.  This time around, bankrupt home builders and defaulted residential mortgage loans were a nationwide source of financial misery.  It was a severe test for American banks from coast to coast.


The Federal Reserve, the Treasury Department, and other regulators, anxious to prevent bank crashes, have over the years devised stringent capital ratios and theoretical “stress tests” by which they hope to fortify U.S. banks and avoid such emergencies.  Most of these regulations were already in place well before 2008-2009, and the banks spent time and money complying with them.  But when the crisis came, they did not seem to help.  They may not protect us next time either.  But these are federal laws, and they remain in force, along with some new ones that were imposed later.  After all, what kind of a government would it be if regulations were scrapped just because they didn’t work?


The financial meltdown of 2008-2009 was a frightening experience, but looking back it serves as a laboratory experiment from which measured results are readily available.  Let us compare some familiar banks to see how well their earnings held up during and after this terrible period.  Look at net earnings per share in the worst year, divided by the best prior year.  The higher this ratio – the less the earnings fell from pre-crisis levels – the stronger the bank’s staying power, from the shareholder’s point of view.

There are some surprises in this table.  It is striking that size of the bank ($ assets), which one might expect to be a point of strength, did not seem to make any difference in how well they rode out the storm.  Some well-managed banks were quite small, yet held up nicely, while behemoths hundreds of times as big suffered appalling losses.  Citigroup, for one, recorded a loss of $32 billion in 2008.  It is one of the mysteries of banking that so much money can disappear without anybody knowing where it went, nor how to get it back again.


Another way to compare the resilience of banks might be to look at the dividends, a crucial feature for investors.  Many (most) banks slashed their payout during the crisis, a major letdown for shareholders who were counting on them for income.  But let us examine how quickly the dividends recovered afterwards.  How much were they paying in 2016, eight years later, compared to pre-crisis levels?

Dividends per share in 2016,

as a percent of best pre-crisis year

Lakeland Financial*                            178%

State Street                                         152%

First Source*                                       133%

Northern Trust*                                  132%

J.P. Morgan                                         124%

Wells Fargo                                         117%

M&T Bank*                                        100%

PNC Financial                                       81%

U.S. Bancorp                                        63%

BB&T                                                     62%

Old National Bank                               57%

Associated Banc-Corp                         35%

Fifth Third Bancorp                              31%

Bank of America                                   10%

Citigroup                                                 2%

* Banks marked * did NOT cut their dividend.  All the others did.

It is apparent that for many banks, the damage suffered in 2009 was significant and is still being felt.  Will they fare better in the next crash, whenever it comes?  Have managements learned from their brush with disaster?  Banks are complicated operations run by honest, dedicated people, and it may be argued that our superficial analysis fails to pick up many of their strengths.  But this article is for investors, who tend to obsess over earnings and dividends.  If those collapse, the shareholders aren’t likely to be smiling.


Written by George Donner

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