Bank Stock Investors: Listen to the FDIC!

The results of the government's stress tests appear to have reassured investors. Bank stocks have enjoyed a massive rally since the market's March 9 low:

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

However, the banking industry isn't out of the woods yes, as data released today from the Federal Deposit Insurance Corp.'s Quarterly Bank Profile makes abundantly clear.

Despite adding aggressively to their reserves in the first quarter in order to offset expected losses, banks have seen non-current loans increase even more quickly. Reserves as a percentage of non-current loans dropped to 66.5% -- a 17-year low -- from 74.8% in the fourth quarter.

The FDIC's chief economist, Richard Brown, also highlighted commercial real estate as one specific area showing increasing stress.

On the bright side, banks recorded an aggregate $7.6 billion in profit in the first quarter, a notable improvement over their $36.9 billion loss in the previous quarter. That's important, because banking profits will enable most (but not all) institutions to earn their way out of the crisis. However, super-low mortgage rates fueled a mortgage refinancing boom, and the industry's normal earning power in the post-bubble era remains a mystery.

I persist in thinking that several hundred banks will fail before this crisis is out. Most of them will be smaller institutions, but investors should be extremely cautious in looking at all banks, large or small. At mid-March prices, bank shares could be purchased with a true margin of safety. Bank stocks' subsequent rise has significantly eroded that margin – in the case of many lesser-quality banks, I'd go so far as to say it's negative, leaving investors facing the prospect of inadequate returns going forward. Be wary!

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