Dueling Fools: The Case Against Investing in Banks Now

We all know the drill: "Buy when there's blood in the streets."

Finding the next Google? That's tough to do. But buying solid stocks when they've been beaten into oblivion is a good way to set yourself up for big gains down the road. So they say.

I couldn't agree more. The big profits are found in stocks nobody wants to touch with a 10-foot pole. If you bought Yahoo! (Nasdaq: YHOO  ) in 2002 when nobody wanted to mutter the words "tech stock," you'd sitting on a four-bagger today. Had you bought a boring company like Altria (NYSE: MO  ) during the dot-com boom, you would have beaten the pants off the majority of then-popular tech stocks.

But before you begin bargain hunting in this bank stock meltdown, it's important to distinguish between two points:

  • Stocks falling because they're out of favor.
  • Stocks falling because they've undergone changes that will hurt them forever.

Amid the current turmoil, I'd venture to say bank stocks fall into the second category. Time to jump in and test the waters? This Fool says don't.

While it might be tempting to pick up our favorite names at (what look like) incredible bargains, bank stocks from Bank of America (NYSE: BAC  ) to Goldman Sachs (NYSE: GS  ) have probably seen the glory days of gargantuan profits fade to black. Here's why.

What goes up must come down. Hard.
Nearly every financial player cashed in on the housing bubble, that huge runup in home prices of the last decade that got way out of hand. Whether it was Countrywide Financial (NYSE: CFC  ) selling a mortgage, Goldman Sachs packaging a CDO, or JPMorgan Chase (NYSE: JPM  ) underwriting a hot new REIT, banks took advantage of the euphoria and reaped huge profits for their shareholders.

The problem is, those days are probably gone for good. After Bear Stearns' (NYSE: BSC  ) blowup last week, it's clear that financial markets still have some serious kinks to work out. But even after everything clears, the banking industry will look very different in the future.

According to a Wall Street Journal article, large banks currently generate 55% of income from noninterest activity -- that is, money earned from fees rather than the profits they make on loans, which is up from 36% in the mid '90s. That doesn't bode well for banks going forward. Why? For one, the Federal Reserve's rate cuts won't do much to help them get back on track.

Interest rate cuts typically help banks make money by widening the spread between money earned from loans and the cost they pay to acquire capital. But when more than half of income comes from noninterest sources, you might as well give antibiotics to a patient who's suffering from a virus. It's good medicine, but not for that ailment.

What's even scarier is that a lot of noninterest revenue was derived from packaging and selling CDOs, many of which rely on residential mortgages. With the slowing housing market comes an equally brutal slowdown in the packaged-securities market that banks thrived on. Suddenly, a division that made huge profits has ground to a halt. And since its base was formed in bubbleland, it's doubtful that we'll see those happy days return anytime soon.

Leveraging trouble?
On top of that, the blistering earnings growth banks enjoyed over the past decade was partly attributable to layering on mounds of leverage. One surefire way to spot a bubble that can't keep its wheels spinning is when companies rely on huge amounts of leverage for growth. Even leader-of-the-pack Goldman Sachs was recently leveraged 26:1, meaning for every $1 of equity, they borrowed enough to support $26 of assets. That's an awful lot of leverage for an industry that can go from hero to zero seemingly overnight.

As banks reassess how much risk they can handle, they'll undoubtedly have to deleverage their balance sheets. That's good news from a risk perspective, but it also means the mammoth profits earned in the past will come back down to earth.

It ain't over till it's over
Will some banks end up doing well? Of course. Banking is one of the oldest and most important industries of our economy, and will be for some time to come. But that doesn't mean we're immune from some serious rough waters ahead, and an even more serious earnings pullbacks once banks get back to more realistic business practices in the future.

Looking for a bargain? Heck, me, too. But just because a stock falls in price, that doesn't automatically make it cheap.

Read Tom Hutchinson's argument for investing in banks.


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12/17/2014 4:00 PM
BAC $17.26 Up +0.54 +3.23%
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GS $185.03 Up +1.72 +0.94%
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JPM $59.77 Up +1.34 +2.29%
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