Don’t Plan the Banking Parade Just Yet

Financial stress tests won't tell us everything we need to know

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Don’t Plan the Banking Parade Just Yet

What’s your take on bank stocks? Almost everyone seems to have an opinion.

Dick Bove, Senior Vice President of Equity Research at Rochdale Securities, believes bank stocks are oversold despite a recent 30%-40% bounce. Bove’s rationale is simple: Banks are being valued at a serious discount to book value when they really should be getting a premium, given the toxic assets that were on balance sheets in the past have been replaced by cash. And he thinks this will be revealed to the world Thursday in the Federal Reserve stress tests.

It’s a great theory, but I wouldn’t start planning the banking parade just yet. Investor confidence still is very tepid. Let’s examine why:

Evaluating bank stocks is a task unlike any other because the valuation metrics are completely different. For example, the Basel III regulations being adopted over the next few years call for a minimum Tier 1 capital ratio of 7% by January 2019. Including the maximum buffers suggested by the Basel Committee on Banking Supervision, the biggest banks in the U.S. could face a minimum of 12.5%. This means that their Tier 1 capital (defined as equity plus reserves minus intangible assets) would have to be at least 12.5% of adjusted assets (defined as total assets minus intangible assets), or what is often referred to as risk-weighted assets.

Wells Fargo‘s (NYSE:WFC) Tier 1 capital ratio as of the fourth quarter 2011 is 11.33%, below this potential hurdle, as is JPMorgan Chase (NYSE:JPM) at 12.3%. Of the five biggest U.S. banks, only Citigroup (NYSE:C), at 13.6%, is above the potential bugaboo.

The trick for investors is determining how likely it is that these additional buffers will come into play. Dick Bove clearly feels they won’t and is betting 7% is more than adequate. How can he be so sure?

Dividends

As a result of the Tier 1 requirements, much of the discussion regarding banks has to do with book value and dividends. The average annual dividend yield for U.S. banks using the KBW Bank Index as a proxy is 3%. According to American Banker, bank holding company dividends are currently about one-third what they were prior to the financial crisis in 2008.

It’s no wonder, then, why bank stocks have been punished so severely. They’re not paying out enough cash to investors, and as a result, those investors are looking elsewhere for their income fix. The current S&P 500 dividend yield of 1.93% is at or near an all-time low, and yet it’s still higher than what you can get at some of those “too big to fail” establishments.

The bank bulls, like Bove, are betting heavily that a clean bill of health March 15 from the Federal Reserve stress tests will unleash a powerful wave of dividend increases and share repurchase announcements that will bring back the dearly departed income investors.

How Healthy Are the Banks?

The problem with this rationale is that investors know better. These tests are nothing but the Federal Reserve putting on a show for taxpayers. Regardless of whether banks are permitted to increase their payouts to shareholders moving forward, it still doesn’t tell us how solvent these 19 banks really are.


Article printed from InvestorPlace Media, http://investorplace.com/2012/03/dont-plan-the-banking-parade-just-yet/.

©2014 InvestorPlace Media, LLC

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