Roundtable: The Biggest Threat to Banking

Although I think there are opportunities in banking, there are many, many risks. So today I asked some Fools who cover the banking sector this question:

If I want invest in banks, what is the biggest threat I should be wary of? Commercial real estate? Credit card losses? Falling housing prices? Derivatives? Government regulation? Something else?

Matt Koppenheffer: If only I could say that a single issue facing the banks was the biggest threat. While banks like Citigroup and Bank of America (NYSE: BAC  ) that were slammed by the financial crisis may have seen the light when it comes to making loans that borrowers can actually pay back, legacy loans will continue to be a problem. This extends from the already problematic mortgage and credit card loans to the commercial loans that are on the edge of their own cliff.

But loans are only the beginning of it all. As long as derivatives like credit default swaps stay unregulated, banks will likely continue to chase them with reckless abandon. As of yet, I don't see any reason why we can't have a repeat of AIG. Meanwhile, many of the banks that we're referring to here -- Bank of America, JPMorgan Chase (NYSE: JPM  ) , etc -- have gone from "too big to fail" to "too bigger to fail" during the crisis, making the stability of the system as a whole even more tenuous than it once was.

And if the government does finally get in gear to crack down on banking abuses, investors may suddenly see the bottom line for the bank they've invested in start to dry up. All in all, between the myriad issues I've noted above, along with the massive run-up in banking stocks over the past eight months, I see investing in big banks right now as a very daunting mine field.

Morgan Housel: Malcolm Gladwell wrote a great article on the trouble with information, where he points out that if Enron fully disclosed its off-balance-sheet workings, its annual reports should have been over three million pages long. Something similar can be said about banks.

That said, I think the biggest risk is the issue of disclosure and transparency. I like to look back at banks' annual reports from 2005-2006 and, with the awesome advantage of hindsight, see if I can find the landmines that eventually blew them apart. Nine times out of ten, you can't. They just don't talk about them. A few examples:

  • Open Citigroup's (NYSE: C  ) annual reports from 2005-2006, and try to find the words "liquidity put." (I'll save you the time: they aren't there). Yet liquidity puts forced Citigroup to repurchase $25 billion of CDOs at full price. At the time, the bank had about $115 billion in equity, so this was something where almost a quarter of the company's equity was at stake, yet they didn't even mention it in the annual report.
  • Read Bear Stearns' annual filings from the boom years. Try to figure out how much of its repurchase agreement financing was termed at 24 hours. They don't talk about it. But this literally made it so the bank could go from "well capitalized" to bankrupt within minutes. Very few people knew this until it was too late.
  • Crack open AIG's (NYSE: AIG  ) annual reports from 2005-2007, and see if you can even remotely begin to comprehend how its derivative operations worked. Within minutes you'll be banging your head on the table, begging for mercy.

So then I ask, OK, if even with hindsight advantage, I still can't figure what happened in the past, how do I expect to do better going forward, especially now that banks are larger and more convoluted today than they were back then? I sure as heck can't, and that's why I stay far away.

Alex Dumortier: Despite multiple series of writedowns and capital raises, the banking sector still faces multiple risks, including:

  • Commercial real estate: Billionaire real estate investor Sam Zell recently told a gathering in Chicago that office and apartment building owners would be able to fill their properties by 2011 or 2012 ... at prices 30% below their peak. Perhaps that's the sort of assumption that prompted Morgan Stanley (NYSE: MS  ) to turn over Crescent Real Estate Equities to Crescent debtholder Barclays (NYSE: BCS  ) last week. The action suggests Morgan thinks the properties are worth less than their debt and that the equity value will remain negative for the foreseeable future.

However, I fear the submerged part of the credit risk iceberg that could put a new hole in the hull of the S.S. Banking Sector is the mass of prime borrowers that are beginning to default on mortgage and credit card loans:

  • Prime borrowers taking on water: According to a survey by the Mortgage Bankers Assocation, 14% of home borrowers were either delinquent or in foreclosure in the third quarter – the highest level since the group began this survey in 1972. Significantly, 55% of loans in foreclosure during the quarter were made to prime borrowers against 37% that were subprime. That shift looks unlikely to reverse as prime fixed -- rate loans also account for a majority (54%) of the increase in loans at least 90 days past due, but not yet in foreclosure. Factor in what I believe will be stubbornly high unemployment and you have a recipe for pain at mortgage lenders such as Bank of America, JPMorgan Chase, or Wells Fargo (NYSE: WFC  ) .

Are these (and other risk factors) reason enough to steer clear of banks? Not necessarily, but they do highlight the importance of requiring a margin of safety, i.e. paying less for shares than a conservative estimate of their intrinsic value. Investors' best bet to achieve that is to look beyond the front-page headlines at smaller, well-run institutions.

What your biggest banking fear? Join the roundtable discussion in the comments section below.

This roundtable article was compiled by Anand Chokkavelu, who owns shares of Citigroup. The Motley Fool has a disclosure policy.


Read/Post Comments (22) | Recommend This Article (53)

Comments from our Foolish Readers

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  • Report this Comment On December 07, 2009, at 1:31 PM, 7footmoose wrote:

    the single biggest threat to investing in banks is CONFIDENCE or more precisely the LACK of CONFIDENCE in the financial system itself on the part of individuals, businesses and governments

  • Report this Comment On December 07, 2009, at 4:55 PM, ehampson wrote:

    The Biggest Threat to Banking - BANKERS!

    Bankers embody greed, arrogance, and stupidity. If they had not embraced the world of finance as a career, they would have been perfect for politics. Same requirements, same qualities.

  • Report this Comment On December 07, 2009, at 5:39 PM, LessGovernment wrote:

    The biggest threat to banking that I see is that the industry will at some point be denied its current ability to avoid accurate financial reporting.

    Mark to market is dead, so there is no impetus to force banks to report true current day values on the balance sheet. If they had to do this today, their balance sheets and their stock prices would be telling an entirely different story.

    Even with the lack of accuracy, something is already happening in the banking sector as can be seen by anyone that is watching. Bank stocks have come off their peaks and have done so in a steady and steep decline.

    Three months ago, WFC was trading at 31.25. Today, WFC is at 26.36 down 16%. The same has happened for C which has fallen from 5.15 to 4.03, down 22% and even BAC has fallen from 18.50 to 15.89, a loss of 14%.

    Obviously, this is not a bull market at this point for these banking stocks, and what do you think will happen when they have to report more balance sheet write downs, or when the Fed will cut of the 0% money?

    Exactly what is it that is going to cause these stocks to go higher other than the greater fool methodology of investors getting desperate for a gain on their investment? I don't see anything to push them higher and a lot of very good reasons why these and other banking stocks can go lower.

  • Report this Comment On December 07, 2009, at 8:00 PM, xetn wrote:

    You guys really are "fools". You talk about lack of regulation and risk as if it didn't extend to all investment. Perhaps it is more so in banking. But the biggest problem in banking is not lack of regulation it is regulation. Government by it lack of economic understanding has, by virtue of its meddling, created the concept of "too-big-to-fail" and via the Fed and FDIC created the moral hazard that provides the "playground" for high risk taking. Eliminating these entities and all government regulation would put the risk that bankers take squarely on their shoulders where it belongs. They would face real failure for their actions.

    As far as a previous posters comments about greed, etc. is just plain ignorant. Greed is a basic human trait and is one of the reasons we are all here on "Fool"; trying to get rich.

  • Report this Comment On December 07, 2009, at 9:34 PM, Sleddawg63 wrote:

    As a Canadian Fool I am driven to distraction by our over-regulated society. But XETN has a point. Banking regulation is good...it certainly has made a huge difference up here.

    Less, but bigger banks, all having to carry a cash float in case of high defaults? No bank bailout up here.

  • Report this Comment On December 07, 2009, at 9:43 PM, Sleddawg63 wrote:

    As a Canadian Fool I will agree with XETN about regulation. I do hate the amount of regulation in this country, but it has worked out well for the banking system during this recession.

    One great bit of regulation was the call for banks to have so much in cash reserves for high default times. Less banks here mean less competition, but I sense too much competition was a bad thing during the mortgage boom in the US.

    I'd call for a "Canadian Style Banking System" but I have seen the response to our health care. lol

  • Report this Comment On December 07, 2009, at 10:05 PM, CntrlAltDel wrote:

    I agree to some extent with my fellow Canadians regarding 'over regulation'. However, I am more inclined to be annoyed by haphazard regulation, i.e., too much here, too little there. In any case, with respect to our banking system, seems it's just about what it should be and should remain as is. What I find most interesting is that Motley seems to think the only banks around are in the US. ALL of the Canadian banks should have been on the Hidden Gems or other portfolios earlier this year so you could double your money.

    Yes, I got Canuck banks in mine:-)

  • Report this Comment On December 07, 2009, at 11:05 PM, SooperB wrote:

    Well as a Canadian I'm not convinced that we are very "safe and secure" from the issues that our fellow Americans have experienced. I'm cetainly not giving our banks a pat on the back just yet. Canadians ARE able to take on massive lines of credit based on inflated appraisals of their homes that the banks are willing to use! Recipe for disaster. Yes this is happening in Canada.

  • Report this Comment On December 08, 2009, at 4:33 AM, weforgot wrote:

    How fast we forget why regulated banks. Prior to the 1930s Free Markets with no regulations allowed banks to do the same thing they have done the last 10 years because of deregualtion.

    Prior to regualtion in the 1930s the Management of the banks pocketed the bonuses and profits and left the depositor with nothing just like they did the last 3 years with deregulation. Deregulaiton made it legal for mangement to pay themselves big boneses and not be held accountable for failure to exercise their Fiduciary Responsiblity to the depositors and shareholders.

    Some of you need to read history before you claim regulations caused the problems. It was deregulaiton that cause most of this last mess.

    We were convince that we were smarter than the older generation and we did not need to regulate financials instutions, that GREED would remain under control and manaagement would not take unnecessary risks to get paid big bonuses at the expense of the depositor and stockholder.

  • Report this Comment On December 08, 2009, at 11:59 AM, TMFTypeoh wrote:

    Did anyone mention the interest rates hikes that are coming down the road? Won't this pinch the profits these banks are spitting out right now, and slow the demand for new loans? Won't that slow down in demand (to say nothing of the new tax credit ending) put downward pressure on home values? Won't that downward pressure on home values cause MORE writedowns, more CDS problems, and MORE unemployment?

    The government has a HUGE incentive to stop this process and reverse it, but i don't know how truly feasible this is. Sure it can delay and postpone by actions of the FED, but it can't change the underlying economics of the situation.

    We need to go down, and hopefully the government can help to make the process less painful. I still liked the idea of nationilizing the banks, or creating a "bad bank" to take all of these loans of the banks balance sheets. This would truly help banks to "bottom", and then they may be worth owning.

    Until this fiasco gets played out, i don't think owning a band is worthwhile unless you play them using options so you can limit your downside. Overall, stay away.

  • Report this Comment On December 08, 2009, at 2:06 PM, TMFKopp wrote:

    @xetn

    While your sentiment is understandable (well, not so much the part where you called us fools), the idea of removing regulation from the banking system is just silly. At its root, the US banking system is far from a free market system, so pretending that there is a free market solution for our problems today is very unwise.

    I recently gave some thoughts on this in another article: http://www.fool.com/investing/general/2009/12/04/stick-a-for...

    Matt

  • Report this Comment On December 08, 2009, at 2:20 PM, Gorm wrote:

    The Big banks that are making money are doing so at the trading desk, and not via their traditional method of lending. That is largely enabled by the Fed persistence in keeping rates so low. I fully believe these low rates are NOT benefiting anyone but the banks BUT the Fed endorses the need for banks to shore up depleted capital.

    In that no recovery is possible without a willing and able banking system I look for market and Congressional pressure to challenge the legitimacy of bank charters and banks' role in the US economy. Banks are doing what is good for them, not America.

    While already HATED for being, at best, stupid in helping create this crisis, their utility will soon be questioned. Increasingly, it is obvious banks prey on consumers to their personal benefit. Without low cost deposits and virtually FREE funding from the Fed banks will end up in a bind.

    While they have a powerful lobby a gutless Congress will have little choice but to clamp down on self-serving banks.

  • Report this Comment On December 08, 2009, at 10:39 PM, wintrwman wrote:

    Well, Congress better get on with it!

  • Report this Comment On December 11, 2009, at 6:51 AM, Glycomix wrote:

    The Fed and FDIC have bought 2 trillion of Fannie Mae, Freddie Mac and the other GSE's crappy Mortgage-backed securities. That puts the entire banking system at risk.

    In 2006, when the GSE's "mortgage backed securities" underwrote only 50% of the mortgage market and congress required a lower percentage of their portfolio to be in "affordable loans" to those who couldn't afford loans, the 14 GSE's "obligations were worth $1.8 Trillion more than their assets" according to Louis Poole, St Louis Fed Governor." When Lockhardt the FHA director put Fannie and Freddie into conservatorship because of their "unsafe lending practices", The GSEs underwrote 76% of all mortgages in the market and the congressional pitbulls in the Congressional Finance Committee harrassed them if they didn't make 52% of their securitized loan guarantees in the form of "affordable housing loans" (loans to the very poor who couldn't afford loans and would dump them).

    We DON'T KNOW how much in the hole Fannie and Freddie were in 2008 and we do NOT know how much in the hole they are today!..

    However,the revelation that Fannie Mae and Freddie Mac were bankrupt in September 2008 caused the world-wide stock-market meltdown and depression that we're still feeling today.

    In the meantime, the banking system stopped making these risky loans, but Fannie and Freddie are STILL making them at a high rate! They are made by risky high profit-high turnover "non-banks" like Ditech that aren't regulated by the FED or the FDIC. However, the FED and FDIC have bought $2 Trillion of the securities issued by the GSE's from mortgages made by these risky lenders.

    The federal government may not be able to respond to stabliize the banking system after another mortgage melt-down because of the current federal debt obligation increase of 1.1 Trillion a year over 10 years (Heritage Foundation, 2009) is more than double the current amount of funds coming into the US treasury of $1 Trillion in 2006 which is much lower today. (IRS report on total income from tax filings in 2006).

    O'Bama wants to put the burden of his social welfare program on the back of businesses. He will have to at more than triple the tax rate.

    These incredible taxes on business will result in business failures, unemployment, brain-drain of the best of the US graduates to other countries without such oppressive taxes (possibly Canada and Europe); '

    We will see the failure of banks and the inability of the Federal Reserve to take over banks because they invested their money in worthless Fannie Mae and Freddie Mac "mortgage backed securities". The American public will lose confidence in the banking system because the FDIC will be unable to pay depositors because of their investments in worthless Fannie and Freddie mortgage backed securities.

  • Report this Comment On December 11, 2009, at 7:09 AM, Glycomix wrote:

    The Fed and FDICs investments into crappy mortgage backed securities issued by Congress' Banks Fannie and Freddie are the biggest threat to Banking security.

    . The GSE's were $1.8Trillion in the hole in 2006 according to Louis Poole who was St. Louis Fed Governor. How much are they in the hole now? When more banks fail, how will the Fed be able to covr them and how will the FDIC be able to reimpurse depositors??

    The Fed and FDIC have bought 2 trillion of Fannie Mae, Freddie Mac and the other GSE's crappy Mortgage-backed securities. That puts the entire banking system at risk.

    In 2006, when the GSE's "mortgage backed securities" underwrote only 50% of the mortgage market and congress required a lower percentage of their portfolio to be in "affordable loans" to those who couldn't afford loans, the 14 GSE's "obligations were worth $1.8 Trillion more than their assets" according to Louis Poole, St Louis Fed Governor." When Lockhardt the FHA director put Fannie and Freddie into conservatorship because of their "unsafe lending practices", The GSEs underwrote 76% of all mortgages in the market and the congressional pitbulls in the Congressional Finance Committee harrassed them if they didn't make 52% of their securitized loan guarantees in the form of "affordable housing loans" (loans to the very poor who couldn't afford loans and would dump them).

    We DON'T KNOW how much in the hole Fannie and Freddie were in 2008 and we do NOT know how much in the hole they are today!..

    However,the revelation that Fannie Mae and Freddie Mac were bankrupt in September 2008 caused the world-wide stock-market meltdown and depression that we're still feeling today.

    In the meantime, the banking system stopped making these risky loans, but Fannie and Freddie are STILL making them at a high rate! They are made by risky high profit-high turnover "non-banks" like Ditech that aren't regulated by the FED or the FDIC. However, the FED and FDIC have bought $2 Trillion of the securities issued by the GSE's from mortgages made by these risky lenders.

    The federal government may not be able to respond to stabliize the banking system after another mortgage melt-down because of the current federal debt obligation increase of 1.1 Trillion a year over 10 years (Heritage Foundation, 2009) is more than double the current amount of funds coming into the US treasury of $1 Trillion in 2006 which is much lower today. (IRS report on total income from tax filings in 2006).

    O'Bama wants to put the burden of his social welfare program on the back of businesses. He will have to at more than triple the tax rate.

    These incredible taxes on business will result in business failures, unemployment, brain-drain of the best of the US graduates to other countries without such oppressive taxes (possibly Canada and Europe); '

    We will see the failure of banks and the inability of the Federal Reserve to take over banks because they invested their money in worthless Fannie Mae and Freddie Mac "mortgage backed securities". The American public will lose confidence in the banking system because the FDIC will be unable to pay depositors because of their investments in worthless Fannie and Freddie mortgage backed securities.

  • Report this Comment On December 11, 2009, at 1:10 PM, Luis50 wrote:

    Your excellent article also has implications for shareholders and plain and simple depositors, who are supposed to take the risk of the entity going bankrupt when in fact it is impossible for them to know their financial situation or to decide on the entity's policies. Bottom line: the only ones fully in charge are the top fat cats who all agree must be paid fat bonuses for their positions.

  • Report this Comment On December 11, 2009, at 2:13 PM, solarfool314 wrote:

    You just have to remember that one of the most dangerous phrases in investment is...

    "Oh, but it's different this time..."

    Yours, Charlie

  • Report this Comment On December 11, 2009, at 3:35 PM, BOB1dot1 wrote:

    Charlie --

    There is a new book out on financial failures titled "This Time Is Different" by Reinhart and Rogoff. Its well worth reading. Some books you cant put down. This one you have to put down just to calm down. The book highlights one common themes preceeding most bank failures is relaxation of regulation. Sound familiar?

  • Report this Comment On December 12, 2009, at 12:19 AM, BothellBrat wrote:

    I wonder what will happen when all those terrible toxic assets begin to turn around in value. I'm seeing some improvement already in the value of my home and perhaps that is a sign that values have bottomed and might just start to increase. Just think of the billions of value available to be recaptured in the future. And as we have seen in the past, we will again see real estate values eventually exceed those at the recent peak. Just like the market hitting 14,000. Ask anyone and the perception is that eventually the market will again hit and exceed 14,000. Good times are ahead. How far ahead is the question. Banks are full of crappy assets right now but wow....just think of the potential they are sitting on.

  • Report this Comment On December 12, 2009, at 10:17 AM, DrGeoff wrote:

    Just because mortgage borrowers are "underwater" does not imply they will default. In southern California in the early 90's when home values fell by 30% to 40% the majority of borrowers did not default. It took the average borrower who purchased a house in 1989 through 1991 about 10 years to get back to the value of the purchase, the rest of the time they were "underwater." However, when a borrower is underwater and their is an economic event (loss of job, wage reductions, divorce, death of an income earner), then there was a default that would lead to a foreclosure and an REO for the bank.

    Banks today face a worse situation because home values fell first, and then the unemployment occurred. This will lead to high default rates for the foreseeable future, and it will lead to house price stagnation for some time. The effects of potentially high default rates and low to falling home prices will not help the rental rates, thus there will be and will continue to be a problem in the apartment market. Thus, this sector will not hurt banks in the future also.

    The real key to all of this the borrowers ability to pay (their mortgages) and their willingness to pay. Since borrower net worth is significantly lower than 2 to 3 years ago, borrowers who have the ability to pay may not be willing to pay if they were on the margin (income wise). Thus, they will default at the same time they will lower their consumption purchases. This will roll through the economy and keep consumption lower than the economy needs, and savings will increase in various ways. This will hurt the commercial loan sector, and thus banks will be hit by this part of the cycle. The cycle will continue regardless of regulation.

    Expect another couple of rough years for consumers, banks, and the USA. Signs of the bottom in the real estate cycle are occurring. In particular, in the hardest hit markets (AZ, CA, NV) there are more private bidders (investors) winning the bids at the foreclosure auctions and banks are finally bidding their net realizable. As more of this occurs the bottom of the market will be realized. Once the bottom is recognized and documented, then the cycle will begin to slow down, banks will begin to lend again, and borrowers will have the confidence to buy real estate with much less fear of falling real estate values. The cycle will begin again.

  • Report this Comment On December 12, 2009, at 8:15 PM, Trustearner wrote:

    I agree wholeheartedly that that putting all our eggs in one basket is a formula for an investing catastrophe.

    When it comes to ethics and regulation, the upshot of it all is that people (including CEOs and Board of Directors of corporations worth trillions) are not angels. Also, in a so-called representative government, hen houses can be and are guarded in many instances by vested foxes.

    In my own investing, which is re-examined on a day-to-day basis, and never subjected to a fixed formula or set of rules, I sometimes avoid precarious things altogehter, such as pharmeceuticals which can go from boom to bust in a heartbeat. Likewise, I'm shying away from the credit industry right now. And, frankly, from an ethics or governance point of view, if there were no criminals there would be no jails, and if no banking firm ever cheated there would be no neef for talk of enforcing upon them any consequences other than "the exegencies of the market dynamic, now would there?

    Criminals make jails. Rip-offers make regulations. And if that government "interference," in anyone's economic or political philosophy, pease excuse me, but burn me once and it's your fault. Burn me twice... it's my fault.

    And, if bankers got out of hand, that's not MY FAULT.

    But danged if I'll just take the position to get s-----d withou a kiss all over again.

    But, hey, if everybody's investing strategey was identical to mine, we would all beat the market on average, over the long term... Wait. What did I say?

    Wait a minute. We can't each beat everybody else.

    Oh my. Maybe I'd better keep my thinking to myself, or everybody will make it hard for me to bet against the crowd.

    Seriously, it's a guessing game, an art and not a science. But as for me, I think the banking industry has been powerful enough and wealthy enough to stack the deck for centuries now, and is not likely to be easily made to be ethical. I'll just put my money elsewhere, thank you. Then if they go up, and nothing else does, I'll be happy for them, and for all who invest in them.

    I don't have enough of a stake to invest in every stock or sector anyhow. And while there is a contest going on over who will be king of the mountain and tell who what to do, let us wonder, which has the most money world-wide and, hence, who has the most power to get its way.

    No regulation is good regulation? Okay, hold that thought while I run for the hills. I'm avoiding bank stocks right now, and I'm definitely not going to invest in "the people of the U.S.," the middle class, or "the government."

    Later, after the dust settles maybe. Not now...

    (:>)

  • Report this Comment On December 14, 2009, at 3:55 PM, VegasMartin wrote:

    Banking is one sector I don't want to own right now and the markets are telling you that the run on banks is over. I will put my money in another sector, thank you very much. The only bank I would consider purchasing is GS at $140 and JPM at $37 should they fall that far.

    http://www.ShootTheBears.com

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