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 Ford (NYSE: F  ) and Rite Aid (NYSE: RAD  ) -- we'd also be talking about the possible bankruptcies of robust companies such as Intel (NYSE: INTC  ) and MasterCard (NYSE: MA  ) .

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 (NYSE: FRE  ) , 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 banks from Goldman Sachs to Bank of New York Mellon (NYSE: BK  ) to pseudo-bank American Express (NYSE: AXP  ) are chomping at the bit to pay back their TARP money.

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.

But I understand why it's tempting. When I see age-old companies with dividend yields over 10% or stock prices in the single digits, I salivate. If bank stocks come back down off their rally highs, banks could make an interesting play (assuming you've satisfied yourself on the three pre-requisites above).

In the meantime, there are a lot of half-off stocks out there with simpler business models than the banking industry. If you're looking for companies selling at attractive prices (with sustainable dividends, to boot), 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.

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

Anand Chokkavelu owns long-held shares of Citigroup (sigh). American Express and Intel are Motley Fool Inside Value picks. Johnson & Johnson is a Motley Fool Income Investor selection. The Fool owns shares of Intel and American Express. The Fool has a disclosure policy.