If You're About to Invest in a Bank, Read This

Yesterday, Bloomberg reported on a new piece of research that suggests there's even more bad news ahead for the banking industry -- if that's even possible at this point.

Specifically, the independent research group CreditSights has estimated that Bank of America (NYSE: BAC), JPMorgan Chase (NYSE: JPM), and Wells Fargo (NYSE: WFC) may have to set aside an additional $30 billion to cover losses on home equity loans.

Those three banks, plus the beleaguered Citigroup (NYSE: C), hold roughly 42% of the total U.S. second-lien mortgage loans. As the plague of negative home equity continues to spread across the country like a financial swine flu, the valuations on those second-liens -- which get bupkis in a foreclosure if the primary lender isn't paid in full -- are coming under fire. Even Congressman Barney Frank has thrown thunderbolts from The Hill, suggesting last month that, "Large numbers of these second liens have no real economic value."

Yet many second-lien loans backed by underwater real estate have been kept on bank balance sheets at full value because borrowers have kept current on their payments.

CreditSights doesn't see this wishful thinking ending well, and therefore estimated that the banks above could see a 40% hit to loans on underwater property. For JPMorgan and Bank of America, the total hit could be nearly as much as expected 2010 earnings, while for Wells Fargo the total may be higher than 2010 earnings estimates.

And while CreditSights focused on the big banks, that doesn't necessarily mean that smaller banks are in the clear. At the end of the year, Fifth Third Bancorp (Nasdaq: FITB) had $5 billion in home equity loans outstanding with loan-to-value ratios above 80%, while First Horizon National (NYSE: FHN) has more than a third of its total net loans in home equity loans.

Shrugging off the pessimism
Assuming that these banks stay solvent -- and CreditSights doesn't seem to be predicting any too-big-to-fail failures -- the bottom line is only part of the bottom line. That is to say, if banks are trading at valuations that take those additional losses into account, the stocks could theoretically still be worth buying.

So let's take a look at the valuations of a few of the banking giants.

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

If the banks are going to continue to close the gap between current and peak valuations, then it'll happen as a combination of gains in the numerator (stock price) and drops in the denominator (tangible book value).

Current Wall Street estimates seem to suggest that earnings will rebound enough that the banks could absorb most of the losses even if CreditSights hits a bull's eye with its analysis. That would mean that rising valuations would have to come from rising stock prices. And if Citi and B of A in particular have the potential to get anywhere near their peak valuations, investors could make a killing.

Or so the bullish pitch would go.

Where's that bucket of cold water?
While that may sound like an enticing story for investors with an eye on banking stocks, I'm far from sold. The problem is that the home equity concerns on the part of CreditSights aren't the problem, they're simply a symptom of a much larger problem.

If you're a frequent visitor to The Motley Fool's website, it won't surprise you to hear me say that main issue for investors is that banks have overly opaque operations and simply haven't given investors any reason whatsoever to trust their reporting. My colleague Morgan Housel has been hammering this message home, most recently highlighting the fact that drastically lowering debt levels at quarter's-end wasn't just a Lehman Brothers game, it's been a nasty practice among most major Wall Street banks including Bank of America, Citigroup, JPMorgan, and Goldman Sachs (NYSE: GS).

The opacity means that it's tough to say whether CreditSights' analysis is really a fair estimate of potential home equity losses or a low-ball figure. It also means that we don't really know what demons are lurking in areas other than home equity. And remember those Wall Street earnings estimates? Black box operations don't give us much opportunity to figure out whether those estimates are really believable.

So if you want to buy stock in the big banks, go ahead. But don't fool yourself -- you simply can't invest intelligently in those banks. As things stand right now, the best you'll be able to do with that shifty group is make speculative bets. Heck, it may go right and make you a bunch of money, but we could say the same about betting on red in Vegas.

If you want to avoid speculation, you may be able to find somewhat more transparent operations along with straight-shooting management among some of the smaller banks. Better still, you may just want to watch the U.S. banking sector from the sidelines until somebody finally gets reform right.

Now I'll kick the ball into your court. Do you think banks are ripe for real, intelligent investment? Scroll down to the comments box and share your thoughts.

Remember when any bank worth its salt paid a decent dividend? I recently opined on why dividends are actually a bummer.