Investing in Bank Stocks

Is Now the Time to Invest in Bank Stocks?

Despite any existing housing and mortgage crises, investing in bank stocks may actually be a profitable endeavor. For the past century, banks and trust companies have usually offered cash dividends and a growing market. Banks are generally capable of weathering financial crises and recovering from them.

Banks make their earnings by buying and selling money. Banks “purchase” money through deposits in checking and savings accounts and CDs, loan and equity financing, bank fees, and other financial services such as asset management and insurance. Banks “sell” money through loans or investing in securities.

Banks Are Facing Earnings Problems

A subprime mortgage crisis can make investors hesitate when considering investing in bank stocks. In addition to the obvious problem of loan defaults, banks lose money because of write-downs (decreasing the value of an asset which had been overvalued), a drop in fee income generated from new mortgages, and general credit deterioration.

Another problem for banks has been the federal funds rate, the interest rate at which banks lend funds to each other, usually overnight. Since the law requires banks to hold a percentage of funds in cash or in a Federal Reserve bank and not use those funds to make money through loans, banks keep as close to that reserve limit as possible and loan as much money as they are allowed to.

When the federal funds rate is low for short-term loans, like a 1 percent rate for overnight loans, at the same time the bank makes long-term mortgage loans of 5.9 percent, the large margin allows the banks to make money. But the federal funds rate has been rising, thus narrowing the margin and resulting in banks making far less money.

Many bank stocks are down more than 50 percent. A significant reason has been, again, a narrow margin between what banks pay in short-term interest rates, such as for a CD, versus what they charge for long-term interest rates, such as for a mortgage. When borrowers default on mortgages, the formula for profitability collapses, leading to low earnings.

What to Look for in a Bank

In researching a prospective bank, investors should take a common-sense approach by looking at a bank’s profitability, asset quality and liquidity, return on assets and return on equity. Investors should also scrutinize a bank’s 10-K report, which is required by the SEC and includes information on company operations, stock performance, financial data, and any legal proceedings.

Despite financial troubles of large banks such as Citigroup and Merrill Lynch, and fear that they could suffer further setbacks, investing in these types of entities is generally a good long-term strategy. Mutual funds managers believe that bank stock prices and valuations currently reflect the worst we will see. After a short-term correction period, bank CEOs will be anxious to start with a clean balance sheet. When these large banks bounce back and regain market share, they promise large returns over the long term.

Regional banks are attractive to investors as well. For regional banks, investors should look at banks that favor commercial loans over residential loans, as commercial loans usually have higher interest rates, more reliable collateral, and typically lead to a more secure client relationship. Investors should also research the demographics of a regional bank, such as local economy, working population, real estate market, wealth, savings potential and deposits, and loan market. Banks with reliable growth in earnings and dividends can be smart selections.

Invest before the Market Bottoms Out

When there is a general financial crisis in the country and recovery is in sight, some experts say that this is the perfect time to invest. If the Fed lowers interest rates, borrowers may be encouraged to take out loans, thereby stimulating the economy, which in turn improves banks’ interest-rate margins.

The old investment adage of buying low and selling high applies here. In an uncertain financial climate, bank stocks are usually good value stocks that can produce substantial returns over the long term.

Strategies for Smart Investment in Bank Stocks

• Trust larger banks that have a proven record of surviving credit crunches

• Look for stocks that pay high dividends, around 5 percent, during unstable financial times

• Look for banks with stable returns on investment