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4 Reasons Banks Still Scare Me

By Morgan Housel – Updated Apr 6, 2017 at 1:21AM

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Think banks are out of the woods? I beg to differ.

Big banks are almost done reporting first-quarter earnings, and investors seem pleased. It was the first time in over a year that the results didn't come strapped to lit explosives. 

Naturally, plenty of investors are calling the bottom and assuming banks' worst days are behind us. Maybe they are. But even that in itself doesn't mean the deep, dark abyss of banking hell is anywhere near over.

Here are four reasons I'm not buying the bank recovery story just yet.

1. Take earnings with a grain of salt
Some banks are making legitimate profits, and that's great. Goldman Sachs (NYSE:GS), for example, is raking it in with fat margins on fixed-income trading.

For others, you have to be careful. Accountants are creative people. Ask a CPA to squeeze net income out of an empty beer bottle, and he could probably get it done. If a company needs to announce profits, it will find a way to do it.

At Bank of America, for example, 98% of net income came from either one-time gains from selling assets or accounting tricks that show "income" when a company's credit spreads blow out -- a sign investors are betting on failure. Citigroup's "profit" was before preferred dividends paid to the government, and would have been a $900 million loss without the same accounting gains on widening credit spreads.

Profits can be manufactured, but when you look at the quality of core business segments, commercial banks are by and large in terrible shape.

2. Just how terrible?
Looking past the vagueness of net income, here's how actual credit quality fared over the past quarter:

Nonperforming Assets as a Percentage of Total Assets

Bank

Q1 2009

Q4 2008

Citigroup (NYSE:C)

1.50%

1.23%

Bank of America (NYSE:BAC)

2.65%

1.96%

Wells Fargo (NYSE:WFC)

1.50%

1.04%

JPMorgan Chase 

1.61%

1.20%

Every major commercial bank saw its loan portfolio deteriorate. Couple that with a warning from B of A CEO Ken Lewis, who told investors "Credit is bad and we believe credit is going to get worse," and, well, you get the idea.

3. The door to nationalization is still wide open
Nothing's official, but CNBC reports that the Treasury's so-called stress test will require banks to have a 3% tangible common equity (TCE) ratio after a worst-case scenario pans out.

Now, forget about "worst-case scenario," some banks are above 3% TCE already. Bank of America sits at 3.13%; Wells Fargo is at 3.28%.

There's a good chance some banks will be forced by the government to raise capital in the coming months. If that capital comes by way of preferred stock conversions, shareholders take a double whammy -- existing investors are diluted, and the market freaks out because Uncle Sam is suddenly a major shareholder. Would you want to own a company where Nancy Pelosi could launch a proxy battle? Me neither.

4. Waiting for the next shoe to drop
Investors seem fixated on the horrors of residential real estate, but banks' biggest concern might be found elsewhere. With losses just now starting to heat up, credit cards are one of the biggest threats these days. Moreover, their losses can be particularly long-lasting due to a strong link to the unemployment rate, which lags the end of a recession.

In just the past 90 days, the banks' charge-off rates have been exploding. Have a look:

Credit Card Charge-Off Rate

Bank

Q1 2009

Q4 2008

Citigroup

9.82%

7.87%

Bank of America

8.62%

7.16%

JPMorgan Chase

7.72%

5.56%

The current unemployment rate is 8.5%, which is terrible. Yet even the Treasury's own outlook calls for unemployment to hit 10.3% under adverse scenarios, and it went as high as 10.8% in the recession of the early '80s -- a period no one ever referred to as an "economic Pearl Harbor," a phrase Warren Buffett used back in the fall to refer to the present.

What impact will surging and stubborn unemployment have on card-centric companies like Capital One (NYSE:COF) and American Express (NYSE:AXP)? That's a question investors who've seen both stocks double over the past six weeks should be asking themselves.

Be honest with yourself
Bank investors have made buckets of money over the past month. That's great. But when fear switches to elation as quickly as it has, while banks' underlying problems are still alive and well, you have to think things are getting overcooked. Assuming everything will be OK without looking at the details is what got us here in the first place.

Related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. American Express is a Motley Fool Inside Value recommendation, and the Fool owns shares of it. The Fool's disclosure policy has batrachophobia; Calaveras County gives it the willies. 

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Stocks Mentioned

American Express Company Stock Quote
American Express Company
AXP
$140.26 (-1.94%) $-2.77
Citigroup Inc. Stock Quote
Citigroup Inc.
C
$44.26 (-2.90%) $-1.32
Bank of America Corporation Stock Quote
Bank of America Corporation
BAC
$31.73 (-2.37%) $0.77
The Goldman Sachs Group, Inc. Stock Quote
The Goldman Sachs Group, Inc.
GS
$301.97 (-3.50%) $-10.95
Wells Fargo & Company Stock Quote
Wells Fargo & Company
WFC
$40.41 (-2.67%) $-1.11
Capital One Financial Corporation Stock Quote
Capital One Financial Corporation
COF
$93.78 (-1.77%) $-1.69

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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