Banks: The Problem That Won't Go Die Quietly

Last week, Dominique Strauss-Kahn, the head of the IMF, told a conference in the U.K. that almost half of total bank losses may remain undisclosed on bank balance sheets. In September, the IMF said that banks have yet to unveil $1.5 trillion in losses. With the credit crisis well into its third year, what's a bank share investor to do?

On the bright side ...
Strauss-Kahn believes that U.S. banks have disclosed a higher proportion of loan losses than their European counterparts. The following table shows aggregate provisions for loan losses and actual net losses for 11 major U.S. banks since the beginning of the credit crisis:

*This aggregate is a sum of quarterly net losses only. It does not include the net income earned during profitable quarters.
Sample: Bank of America, BofA Merrill Lynch, Bears Stearns Companies, Citigroup, Goldman Sachs, JPMorgan Chase, Lehman Brothers Holdings, Morgan Stanley, Washington Mutual (bankrupt), Wachovia Corporation (acquired), Wells Fargo.
Source: Capital IQ, a division of Standard & Poor's.

In his formal remarks, Strauss-Kahn said that "banking systems in many advanced economies remain undercapitalized, weighed down by leaden legacy assets and, increasingly, non-performing loans." Banks may be reluctant to recognize further losses, as it would shine a light on their capital shortfall.

S&P's handwriting on the wall
Last week, I highlighted some research from Standard & Poor's (a unit of McGraw-Hill (NYSE:MHP)) that suggested that many of the world's largest banks (including some U.S. institutions) would need to raise additional capital. A few readers took me to task due to the fact that S&P's capital ratios were calculated based on end of second-quarter data and did not, therefore, account for any capital raises that have occurred since then. This is, in principle, a valid point, but, as the following table shows, I don't see much evidence that major U.S. banks were substantially better capitalized at the end of the third quarter:

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

Investors must be vigilant
With that in mind, I'll reiterate my warning to bank share investors: Understand that there is a risk of share dilution and verify that current prices maintain a margin of safety to compensate you for that risk (the massive rally in financials has certainly eroded that margin). In an upcoming Banking Roundtable, I'll be giving my three predictions for the banking sector over the next 10 years; my hunch is that the shakeout has barely begun.

The Federal Reserve's current policy is creating tangible risks for investors. Global Gains co-advisor Tim Hanson explains why you need to get out now!