You Can Still Lose Your Shirt Investing in Banks

In some respects, the U.S. banking crisis is in the rearview mirror. In other respects, it's anything but.

The whole "robo-signing" foreclosure debacle has been front-page news and has put major heat on big banks like Bank of America, JPMorgan Chase, and Wells Fargo. While the big boys have more or less stood behind their work, mistakes have definitely been made and it's unlikely that we've heard the last of this.

Meanwhile, foreclosures have been on the rise all over the country. The familiar names -- California, Florida, Nevada, and Arizona -- remain the league leaders, but areas such as Seattle, Chicago, Houston, and Atlanta saw a hefty bump in foreclosure activity over the summer.

Top that all with a healthy dose of risk-aversion keeping a lid on new loan demand and you've got a pretty lousy picture for the banking industry.

Banking bombs
My fellow Fool Anand Chokkavelu thinks the perceived risk from the big boys in the banking industry may have created some bargains. As part of the Fool's Rising Stars program, Anand picked up shares of both B of A and JPMorgan.

He may be right. The big banks have been under so much scrutiny that, if anything, they may have overprovisioned for bad loans. And let's be honest, regardless of what the reform bill may be saying, these banks are all still too big to fail and Uncle Sam is doing everything possible to make sure they succeed.

Among the smaller banks, however, some investors have seen just how wrong things can go. Just yesterday, Wilmington Trust announced that it was being acquired by M&T Bank (NYSE: MTB) for roughly half of what its shares fetched last Friday. In a similarly gulp-inducing move, last week Flagstar Bancorp (NYSE: FBC) announced a share offering that priced $380 million of new common and preferred shares at less than half of what the stock was trading for the day before. Over on the West Coast, Pacific Capital Bancorp (Nasdaq: PCBC) shares are still digesting the upcoming rights offering that will allow record-date shareholders to buy shares at $0.20 each.

Three steps to share decapitation
Why have these banks ended up getting their heads handed to them by Mr. Market? Other than unhelpful statements like "they screwed up," there's no easy answer that wraps all the factors up in a nice package. However, investors focusing on the following three points would have likely avoided these stinkers altogether.

1. Watch the trend. No, I'm not talking about technical analysis; I'm talking about the state of the banks' loan books. The banking mess may not be over yet, but many banks have seen their books begin to stabilize or even move in the right direction. Most of the banks getting clobbered, however, have seen significant continued credit deterioration.
   
   
2. Generous provisions. Banks set aside reserves for loans they think might go bad. Some banks take a particularly conservative approach to this, reserving enough to cover all (or more!) of their nonperforming loans, while others play it a little tighter. I prefer to see higher levels of provisions since that gives banks a cushion against worse-than-expected loan deterioration.
   
   
3. Capital to avoid punishment. If a bank's ratio of capital to assets is too high, then the bank will have trouble earning acceptable returns for its shareholders. In these trying times, though, it's tough to overstate the importance of healthy capital ratios. While there are a handful of measures of bank capital, an easy one is common equity to assets. Look for banks that have a ratio of at least 9%.

Better bets
Putting those three points above into action, let's take a look at a few banks that may be better bets for investors.

Source: Capital IQ, a Standard & Poor's company.
Note: East West Bancorp loan-loss provision ratio adjusted for assets covered under FDIC loss-sharing agreement.

While I think all four of the banks above could be winning tickets for investors, I also think a basket approach may be the best bet in this sector right now. That is, rather than falling head-over-heels for a single bank stock, investors are probably better off finding a handful of healthy and well-run banks and investing in all of them.

Why the diversified approach? Because a lot of the most important metrics rely on internal expectations and estimates, and when the situation turns out to be worse than anticipated, things can go bad fast. For evidence of this, look no further than Wilmington Trust, where shareholders were no doubt in utter shock as they watched the bank's loans sour at an alarming rate and the bank get sold for a huge discount.

By focusing on the strongest banks and not putting all their eggs into one banking basket, investors can benefit from the continued recovery in the sector with less concern of a single radioactive bank nuking their portfolio.

Banking isn't the only way to get financial sector exposure. My fellow Fools have identified three financial sector profit plays that could soon have a gale-force wind at their backs. To get the free report, click here and enter your email address.