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Yesterday, Bloomberg reported on a new piece of research that suggests there's even more bad news ahead for the banking industry -- if that's even possible at this point.

Specifically, the independent research group CreditSights has estimated that Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , and Wells Fargo (NYSE: WFC  ) may have to set aside an additional $30 billion to cover losses on home equity loans.

Those three banks, plus the beleaguered Citigroup (NYSE: C  ) , hold roughly 42% of the total U.S. second-lien mortgage loans. As the plague of negative home equity continues to spread across the country like a financial swine flu, the valuations on those second-liens -- which get bupkis in a foreclosure if the primary lender isn't paid in full -- are coming under fire. Even Congressman Barney Frank has thrown thunderbolts from The Hill, suggesting last month that, "Large numbers of these second liens have no real economic value."

Yet many second-lien loans backed by underwater real estate have been kept on bank balance sheets at full value because borrowers have kept current on their payments.

CreditSights doesn't see this wishful thinking ending well, and therefore estimated that the banks above could see a 40% hit to loans on underwater property. For JPMorgan and Bank of America, the total hit could be nearly as much as expected 2010 earnings, while for Wells Fargo the total may be higher than 2010 earnings estimates.

And while CreditSights focused on the big banks, that doesn't necessarily mean that smaller banks are in the clear. At the end of the year, Fifth Third Bancorp (Nasdaq: FITB  ) had $5 billion in home equity loans outstanding with loan-to-value ratios above 80%, while First Horizon National (NYSE: FHN  ) has more than a third of its total net loans in home equity loans.

Shrugging off the pessimism
Assuming that these banks stay solvent -- and CreditSights doesn't seem to be predicting any too-big-to-fail failures -- the bottom line is only part of the bottom line. That is to say, if banks are trading at valuations that take those additional losses into account, the stocks could theoretically still be worth buying.

So let's take a look at the valuations of a few of the banking giants.


Pre-Crisis Price-to-Tangible Book Value Peak

Mid-Crisis Price-to-Tangible Book Value Trough

Current Price-to-Tangible Book Value

Wells Fargo




Bank of America












Source: Capital IQ, a Standard & Poor's company.

If the banks are going to continue to close the gap between current and peak valuations, then it'll happen as a combination of gains in the numerator (stock price) and drops in the denominator (tangible book value).

Current Wall Street estimates seem to suggest that earnings will rebound enough that the banks could absorb most of the losses even if CreditSights hits a bull's eye with its analysis. That would mean that rising valuations would have to come from rising stock prices. And if Citi and B of A in particular have the potential to get anywhere near their peak valuations, investors could make a killing.

Or so the bullish pitch would go.

Where's that bucket of cold water?
While that may sound like an enticing story for investors with an eye on banking stocks, I'm far from sold. The problem is that the home equity concerns on the part of CreditSights aren't the problem, they're simply a symptom of a much larger problem.

If you're a frequent visitor to The Motley Fool's website, it won't surprise you to hear me say that main issue for investors is that banks have overly opaque operations and simply haven't given investors any reason whatsoever to trust their reporting. My colleague Morgan Housel has been hammering this message home, most recently highlighting the fact that drastically lowering debt levels at quarter's-end wasn't just a Lehman Brothers game, it's been a nasty practice among most major Wall Street banks including Bank of America, Citigroup, JPMorgan, and Goldman Sachs (NYSE: GS  ) .

The opacity means that it's tough to say whether CreditSights' analysis is really a fair estimate of potential home equity losses or a low-ball figure. It also means that we don't really know what demons are lurking in areas other than home equity. And remember those Wall Street earnings estimates? Black box operations don't give us much opportunity to figure out whether those estimates are really believable.

So if you want to buy stock in the big banks, go ahead. But don't fool yourself -- you simply can't invest intelligently in those banks. As things stand right now, the best you'll be able to do with that shifty group is make speculative bets. Heck, it may go right and make you a bunch of money, but we could say the same about betting on red in Vegas.

If you want to avoid speculation, you may be able to find somewhat more transparent operations along with straight-shooting management among some of the smaller banks. Better still, you may just want to watch the U.S. banking sector from the sidelines until somebody finally gets reform right.

Now I'll kick the ball into your court. Do you think banks are ripe for real, intelligent investment? Scroll down to the comments box and share your thoughts.

Remember when any bank worth its salt paid a decent dividend? I recently opined on why dividends are actually a bummer.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.

Read/Post Comments (9) | Recommend This Article (31)

Comments from our Foolish Readers

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  • Report this Comment On April 13, 2010, at 5:08 PM, sondo1313 wrote:

    I do the opposite of what you kids advise. So thanks, and go JPM tomorrow!

  • Report this Comment On April 13, 2010, at 5:52 PM, rd80 wrote:

    "the valuations on those second-liens -- which get bupkis in a foreclosure if the primary lender isn't paid in full"

    This isn't necessarily true. Most second-liens are full recourse loans while most first mortgages are non-recourse. In the non-recourse loan, the lender's only remedy in case of default is to seize the property. In the full recourse loan, the lender can go after assets other than the home or wages the borrower may have.

    Therefore, it's very possible that a second-lien loan could have some value even if a foreclosed property isn't worth enough to satisfy the first lien.

  • Report this Comment On April 13, 2010, at 7:06 PM, TMFKopp wrote:


    "I do the opposite of what you kids advise. So thanks, and go JPM tomorrow!"

    JPM? Really? If you're going to speculate on the banks at all, why not go for the gusto and go for C and BAC, both of which have more potential upside than JPM. The herd has been with JPM all along...


  • Report this Comment On April 13, 2010, at 7:13 PM, TMFKopp wrote:


    "Most second-liens are full recourse loans while most first mortgages are non-recourse. In the non-recourse loan, the lender's only remedy in case of default is to seize the property. In the full recourse loan, the lender can go after assets other than the home or wages the borrower may have."

    First of all, you're kind of right on the first part. Most second-liens are recourse loans, but it's not really true that most firsts are non-recourse. There are states that are non-recourse (Arizona and California as prime examples), but most firsts are still recourse.

    As for the fact that seconds are usually recourse, theoretically you're right that the lender will end up with something more than squat, but in practice that's not really true. The process of going after the borrowers is costly, and if they've already defaulted on their mortgage it's highly unlikely that they've got a high-paying job (or a job at all) and even less likely that they've got a ton of free assets sitting around that the lender can grab.

    The primary collateral for both borrowers is the real estate itself and if the home is underwater then the junior lender is in a pretty bad position. Any way you cut it, once the underlying real estate is underwater, there's no way that second-lien loan should be held at full value.


  • Report this Comment On April 13, 2010, at 8:33 PM, rd80 wrote:

    I stand corrected. I had thought first mortgages in most states, at least for purchase, were non-recourse. A quick Google search showed that's not the case.

    Concur that most folks who default would not be likely to have other assets. One exception would be jingle mail where the borrower could make the payments, but decides to default because the home equity is way upside down.

  • Report this Comment On April 16, 2010, at 10:36 AM, crowhunter wrote:

    there are a number of small local banks that are quite healthy. However, the taint has spread throughout the entire industry and the future is most unsure. Extreme caution should rule the day. I am trying to unload a large position before the end of the year. there may be many others trying the same thing and that will drive down the overall market for bank stocks. This is a mess! jfs

  • Report this Comment On April 16, 2010, at 2:00 PM, markyaney wrote:

    Small banks are where its at, but rewarding banking, broadly for helping largely to enable the current state is not a natural motion of the invisible hand. A spanking would be more natural.

  • Report this Comment On April 16, 2010, at 3:51 PM, Labnomore wrote:

    Why even think of investing in US banks when there are stable, well run, well regulated banks in Canada trading in the US?

    When capital is flowing into Canada at a rate which enables us to keep rates down and appreciate the Can buck?

    When they have just come off a stellar 1Q?

  • Report this Comment On April 16, 2010, at 4:03 PM, rochab2 wrote:

    If you are about tgo purchase a bank stock, look north of the border at Canadian bank stocks which trade on the New York Exchange, bmo td ry, all doing very well not exposed to the same issues as U.S. banks, all pay a decent dividend.

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