Will Bank Losses Be Worse Than in the Great Depression?

On Monday, CLSA analyst Mike Mayo dropped some napalm on the banking sector, suggesting that the future looks bleak thanks to the fact that banks have committed "the seven deadly sins of banking." Those sins, according to Mayo are: "greedy loan growth, gluttony of real estate, lust for high yields, sloth-like risk management, pride of low capital, envy of exotic fees, and anger of regulators."

Creativity aside, the meat of Mayo's report was that he believes that loan losses at banks will continue to accelerate and will likely hit between 3.5% and 5.5%, or noticeably above the 3.4% level reached during the Great Depression. While mortgage loans are a substantial piece of the lending pie and have been the primary focus so far, Mayo sees acceleration from other areas including home equity, credit cards, and construction loans.

Maybe even more disconcerting about Mayo's take is that he estimates loans on the banks' books -- with the exception of acquired banks like Wachovia -- have been marked down to only $0.98 on the dollar, which would seem to hardly reflect current conditions. Not only could this mean future losses for the banks as they come to terms with those loans, it could also jab a stake into the heart of the government's program to buy toxic assets from the banks. After all, if banks are trying to sell junk at a premium, buyers may not stay at the table very long.

These conclusions led Mayo to open up with underperform ratings on Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , JPMorgan (NYSE: JPM  ) , Wells Fargo (NYSE: WFC  ) , PNC Financial, and Comerica. Meanwhile, he slapped an even harsher sell rating on US Bancorp (NYSE: USB  ) , SunTrust, Fifth Third (Nasdaq: FITB  ) , KeyCorp, and BB&T (NYSE: BBT  ) .

What I think Mayo's report highlights in particular though, is that there is still a very high level of opacity in the worst-hit banks. While there is a sense that the flood of loan losses could continue to rise, there doesn't seem to be any clear grasp on who's holding what and what's been realistically marked down. It seems like the government is either too scared to look at the books because of what it might find or it's too timid to lay down the law. You'd think that hundreds of billions of dollars in direct government aid and hundreds of billions more in loan guarantees would say it's time for us to get somebody in there tearing apart the books to figure out what we're really dealing with.

Is temporary nationalization the only solution? Does the Public-Private Investment Program really have any hope of succeeding? It's quite clear that the banks have been sinners for some time now, but I don't see how we can determine the optimal flavor of penance until we're doing more than guessing about what's lurking in those banking vaults.

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Fool contributor Matt Koppenheffer owns shares of Bank of America, but does not own shares of any of the other companies mentioned. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...


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  • Report this Comment On April 07, 2009, at 12:09 AM, BellasPosting wrote:

    Every time the market rallies, the short sellers and their minions state something to drop prices and scare people out of the market. Great for the shorts, but lousy for the stock market. Since I've never heard of this "expert", his OPINION means squat to me.

  • Report this Comment On April 07, 2009, at 6:02 AM, 64bitfool wrote:

    First, Matt Koppenheffer should (please) examine the history of Mike Mayo's reports and his access to the books of Bank of America (BAC) for example. This guy hasn't had anything good to say about anyone, ever.

    Versus other "real" analysts (people that actually audit the establishments that they are providing analysis of) that have (especially in the past month) been "checking things twice"; Mayo appears to have no clue. Rather, he's bundling everyone in the same basket.

    There is no mention of the huge new transactions savings/profits (from BAC now owning Merrill, that they used to pay to other people every day), nor of the overall stability reflected by the fact that the majority of borrowers as well as BAC both want (and are successfully executing) "to term" lending relationships. This means both the bank and the "majority" of real estate and other loans are continuing to return profits.

    To add insult to injury, there are so many people misreporting the real value of the M2M changes to BAC, it is ridiculous. Even "the street" continues to misreport the fact that M2M can (and will!) be applied to the first quarter (while they have twice said it will be the second quarter; the document clearly indicates that the changes are to be applied in the first quarter!). This will give the already "in the black" BAC even larger 1st quarter dividends and after the first quarter financials are reported, a much higher street price.

    If you think you've read it all, you should take a look at Dick Bove's analysis. Mr. Bove who has traditionally been one of the most conservative guys out there and harshest critics of banks in general over the past two years, now estimates that BAC could see $30B pre-tax earnings as soon as 2011 and has set an interim target at $14! Yes, TWICE the current price.

    As for negative news, the real damage was already done in the last two quarters with BAC writing down assets far below actual value (necessitated by M2M rules) and writing off what will probably turn out to be more than they had to regarding the Merrill buyout. While that hurt people still in owning BAC shares during the last three quarters, those write-downs will actually help BAC stock recover this quarter when the adjustments come.

    As for the practices of "give a negative report and short the stock", yes it needs to be (and probably is being) investigated. I watched in horror as Cramer told people to buy BAC and not three days later he struck a match to light a fire conveeeeeeeeniently following some huge new shorts. What I really want to know is, "Where the hell is the Wall Street Journal?" and the SEC while this is going on? These things don't "just happen" and the patterns of pushing after-hours trades and then huge opening shorts are troubling as well.

    Also conveniently, I keep hearing negative press about BAC and other banks (as a bundle), but it is always the same situation: The people writing these papers (and those adding their own spin) have never actually seen the books or examined the specific profit centers of the people they are talking about, Given that fact, I can't see how they (or anyone else that hasn't done their homework) can even comment.

    Regarding Bank of America, I can't see how getting in at any point under $10.00 is a mistake. The dividends for the first quarter alone make this a no-brainer. I mean just that one thing should make this a $10.00 stock. While life after the first quarter could be a bumpy ride through the third quarter, I don't see how this stock isn't $15 to $20 by the end of the year and dramatically better thereafter.

    The critics would say that $10 is unreasonable given the stock hit $5.00; but don't forget what the "facts" were when that was case. The situation has dramatically changed and just because it took 3 quarters to bottom out, those days have come and gone and now you need to look at the books and simply do the math.

    One last thing to note. After those write down's from the 4th quarter, the bank's CEO and a few board members now find their necks on the chopping block with a potential proxy fight at the next stockholders meeting.

    Does anyone seriously believe that BAC management will fail to dramatically reward stockholders given their jobs are on the line? Think again.

    I spent two months examining BAC financials following the Merrill buyout (and yes, I too think BAC paid probably $5-7 more than they should have for Merrill) and I stayed completely out of the market until last month. I have been steadily buying BAC over the past 30 days and it now represents 30% of my overall investment portfolio. I also plan to buy $20 2011 leaps in the next week while the prices are still reasonable.

    In closing, I want to explain why I have taken the time to write all of this. First, I don't care if you believe in BAC or not. I'm not in it for you, I'm in it for me. Next, I am not greedy but how can I walk away from potentially a 5 to 10+% dividend that EVERYONE knows is coming? Sure, you needed to get out of BAC last year, but that was then! Show me another company that can give me a chance to get in at the lowest price ever, yet is going to pay me a dividend in the first quarter and then will grow dramatically in the next few years. If you can find even one other single stock that can do that, and I'll buy it too!

  • Report this Comment On April 07, 2009, at 6:12 PM, kgeechee wrote:

    I FULLY agree with the comment on Short Selling! In what other MAJOR business transaction can one sell something one does not own nor intend to buy? Can one sell a cat, house, cow, anything with the promise that the item will be purschased for delivery some unidentified time later.....perhaps never?

    Commodities & Options are close, however a time is specified, none for shorts.

    Shorts benefit so few that it is hard to understand why the MARKET protects the Shorts.

    Hang 'em HIGH!

  • Report this Comment On April 07, 2009, at 6:31 PM, bobcollins wrote:

    Thank you 64bitfool, I will put your info to use and decide if it's for me....any thoughts on Wells Fargo?

  • Report this Comment On April 07, 2009, at 7:29 PM, xetn wrote:

    Short selling helps rationalize the price of a stock or commodity and performs a very valuable service as it provides liquidity to the markets. And, don't forget that there are always two sides to the equation; the seller and the buyer. You may not like short selling, especially if you happen to own one of the stocks that is being shorted, but that's life. Lastly, shorting is a very risky transaction so the shorter is got his neck way out, because there is no limit to losses, such as in options.

  • Report this Comment On April 07, 2009, at 11:09 PM, BellasPosting wrote:

    Short sellers are like the gamblers who bet against the shooter in craps. They have anti-social and negative personalities. Unlike normal investors, who buy a stock because they believe in a company, shorts are betting against a company and it's stock. They're hoping a company will fail so they can profit. And if it doesn't fail, they try to manipulate the stock into failing. How is that ethical, or legal, for that matter? Shut down the shorts and you will see a stable stock market. The only people who benefit from these wild swings in the market are the short sellers. Time for the government to put them in their place.

  • Report this Comment On April 09, 2009, at 6:13 PM, medoran wrote:

    Matt's question concerning temporary nationalization of banks struck me as being an oxymoron. Anytime the government gains control of something, they don't let go. Temporary is not in their vocabulary, especially when it comes to money and power....which is just about everything. The Pentagon was supposed to be temporary. Many tax laws were supposed to be temporary. A pletora of social programs were supposed to be temporary. But they are still in force. Perhaps another question. please!

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