Better Buy: U.S. Bancorp vs. Bank of America

This edition of Better Buy places two of Warren Buffett's favorite bank stocks against one another with Bank of America (BAC -0.21%) and U.S. Bancorp (USB 0.32%). All banks are currently in the midst of a turbulent economy, making either choice a risky play, but also with substantial upside. Since Feb. 20, when the market really began to fall, Bank of America's stock is down about 37%, while U.S. Bancorp's stock is down about 40%.

While I don't think either is necessarily a bad play, I would invest in U.S. Bancorp after seeing first quarter earnings reports. Not only did U.S. Bancorp report a smaller drop in earnings in the first quarter than Bank of America, but it also had a lower credit provision and more confidence that it would be able to maintain its current dividend throughout the year.

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The credit provision

Although Bank of America is much larger than U.S. Bancorp in total assets, the two have some similarities in their portfolios. For instance, credit card loans make up 9% of Bank of America's portfolio and 8% of U.S. Bancorp's portfolio, while non-interest income makes up about 46% and 44% of their total revenue, respectively.

So, it was a little surprising to see Bank of America report a much larger increase in its credit provision (cash banks set aside for future loan losses) than U.S. Bancorp. Bank of America's provision of nearly $4.8 billion in the first quarter is up more than 500% from the linked quarter, while U.S. Bancorp's provision of $993 million was only up about 250% from the linked quarter.

At first glance that might be alarming, but U.S. Bancorp does seem to have some solid fundamentals behind its asset quality. The weighted average FICO score in U.S. Bancorp's residential mortgage portfolio is 766, according to the company, while the average loan-to-value (LTV) ratio is 69%, which is strong . The LTV ratio is the mortgage loan amount divided by the property value, showing how much money a borrower has put down as a down payment on the property. So, a typical LTV on a single-family home is 80% because the conventional home buyer makes a 20% down payment. Therefore, the lower the LTV, the safer the loan is. U.S. Bancorp's LTV on its commercial real estate loans is also 60%.

Additionally, even though the provision increase might have been smaller than some of the other larger banks, U.S. Bancorp's total reserves were 2.07% of total loans at the end of the first quarter, while Bank of America was at 1.51%. That means that despite the lower quarterly credit provision, the bank has more total cash set aside for losses in its loan portfolio than Bank of America. If U.S. Bancorp can manage to keep its provision lower than its peers in upcoming quarters, then it will be in good shape compared to the industry as a whole.

Maintaining the dividend

All U.S. banks are trying to maintain their dividends, but this goal will be put to the test as total reserves grow, putting pressure on the eligible capital banks can pay out to shareholders.

An important metric to watch in regards to the dividend is the common equity tier 1 capital (CET1) ratio, a measure of a bank's core capital to its risk-weighted assets. If this ratio falls below a certain threshold, banks are restricted to how much in capital distributions they can pay out of their eligible retained earnings.

Bank of America's CET1 ratio fell to 10.8% at the end of the first quarter. Because it is one of the "global systemically important banks" (G-SIB) defined by regulators, Bank of America has to keep this ratio above 9.5% to avoid payout restrictions on eligible retained income . If it falls below this buffer, the bank would be limited to a 60% payout of eligible retained income. Now, it could probably still pay out dividends at this level, but it might be closer to at least considering cutting the dividend at that point.

U.S Bancorp is not a G-SIB and therefore only needs to maintain a CET1 ratio of 7% to avoid payout restrictions. After the first quarter, its CET1 ratio had fallen to 9%, leaving it more wiggle room than Bank of America. Plus, U.S. Bancorp executives on the company's recent earnings call seemed very confident about continuing to pay its normal dividend. Chairman, President, and CEO Andrew Cecere twice said on the call that even if an economic downturn persisted through most of the year, he thought the company would be able to maintain its current dividend.