Is It Time to Buy Banks?

After processing the latest plans to save our financial system, I'm tempted to buy a bank stock.

See, Mr. Market kicked my butt last year. And I want some revenge. What better way than to be contrarian and pick up shares in the most beaten-down, toxic, left-for-dead-even-factoring-in-this-recent-rally sector this side of the homebuilders?

Why not?
It's not as if we're still worried that banks are going under. After all, the government has made it clear that the largest banks aren't going anywhere. Those that were already too big to fail only got bigger:

  • Bank of America swallowed up Countrywide and Merrill Lynch.
  • JPMorgan Chase grabbed Bear Stearns and Washington Mutual.
  • Wells Fargo took over Wachovia.

Some of the worry that the banking behemoths would be allowed to fail started to dissipate when Bank of America and Citigroup got second helpings of TARP love. And the residual worry was almost completely eliminated after the government released their feel-good stress-test results.

See, too much is at stake. As fellow Fool Richard Gibbons explained, the lending that banks provide allows our whole economic system to operate. Without this credit, we wouldn't just be talking about the impending collapse of companies with inherent problems, such as UAL (Nasdaq: UAUA  ) and Beazer Homes (NYSE: BZH  ) -- we'd also be talking about the possible bankruptcies of robust companies such as Cisco (Nasdaq: CSCO  ) and Visa (NYSE: V  ) .

And we won't even get into what would happen to credit-dependent medium-sized businesses, mom-and-pop shops, and individuals.

The banks -- and the banking industry -- will definitely survive.

But what about price survival?
So, the banks will survive. They must. But -- and this is why temptation hasn't turned to action -- survival doesn't necessarily mean that shareholders will benefit.

Just ask the people who owned Fannie Mae, Freddie Mac, and AIG.

Yes, the government will continue to throw lifelines to the banks, but the implications for the banks and their shareholders are still undetermined. As shown by the recent curbs on executive pay at companies receiving TARP funds, the government can and will make the costs of those lifelines increasingly punitive. It's no coincidence that big banks like Goldman Sachs and JPMorgan Chase are jumping at the chance to pay back TARP funds. Same with mid-tier players like State Street (NYSE: STT  ) , Capital One (NYSE: COF  ) , and Northern Trust (Nasdaq: NTRS  ) on down to the community banks.

And even after the stress tests, this may not be the end of it. Recall that the rescue of Bear Stearns last March was supposed to prevent a financial collapse. It didn't. A year later, we're still groping for a stable plan of action.

The government has many tools at its disposal -- from the purchase of toxic assets to capital injections all the way on up to complete nationalization. And each of these options could be executed with very favorable -- or very unfavorable -- terms for the banks and their common shareholders.

Think positive?
Now, I'm a confirmed optimist, but given the government-intervention wild card, buying the banks has been more speculation than investing. However, I believe that the stress tests have provided a lot more clarity around the government's likely course of action -- in my mind, the government has signaled that it will avoid nationalization at all costs (though this may still mean more massive share dilution).

Still, even after discounting government-related uncertainty, to invest in a bank, we must thoroughly understand the balance sheet of that bank.

And that's virtually impossible in the case of investment banks, especially now. Understanding even one derivatives contract is daunting; properly assessing the risks of a whole portfolio of derivatives contracts, jacked up with leverage and swapped back and forth by mis-incentivized traders, is more Einstein than Joe Investor.

Thus, I wouldn't touch shares of Goldman Sachs, despite its status as a finishing school for Treasury secretaries. And if I wouldn't touch Goldman, I certainly wouldn't touch Morgan Stanley.

But even when we're talking about banks that have stuck to their commercial banking roots, avoided risky megamergers, and seemed to navigate the subprime debacle well -- like BB&T and US Bancorp -- we still can't be sure.

Don't believe that the "healthy" banks are healthy just because nothing bad has come out yet. We've seen again and again in this crisis that everything is fine until it isn't.

Talking us off the ledge
So, I would advise against buying a bank stock unless you have three things: particular insight into bank balance sheets, an unshakable faith in that bank's management, and comfort in speculating on the final form of the government bailout initiatives.

There are certainly banking opportunities out there -- some now and some if we come down off the recent rally highs. For those who meet the three criteria I laid out above, it's homework time.

For those who put banks in the "too difficult" bucket, there are a lot of half-off stocks out there with much simpler business models. If you're looking for companies selling at attractive prices that feature the stable dividends bank stocks used to provide, I invite you to view our Motley Fool Income Investor team's recommendations. A 30-day trial is free. Just click here to get started.

Already subscribe to Income Investor? Log in at the top of this page.

This article was first published Feb. 24, 2009. It has been updated.

Anand Chokkavelu owns long-held shares of Citigroup (sigh). The Fool has a disclosure policy.


Read/Post Comments (0) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 927133, ~/Articles/ArticleHandler.aspx, 12/18/2014 1:31:14 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement