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Last Wednesday the markets were comforted by Fed chairman Ben Bernanke’s comments that the US economy is in a nascent recovery that requires interest rates to be kept low. Banks are breathing a sigh of relief that the recent rise in the discount rate will not lead to a significant rate increase. Even the Fed will begin to tighten in the near future, and the yield curve remains very steep, meaning the difference between short and long term rates is very wide.

Yield-seeking investors have traditionally looked at big banks to boost income, which used to offer solid balance sheets with good cash cushions and nice dividend yields. The financials have recovered somewhat. However, after the recent meltdown, this sector still leaned heavily on government support in order to survive. It is unlikely to restore juicy dividends soon. In addition, banks have to be in capital preservation mode because new regulations might require them to hold higher levels of T1 capital ratio.

Major Financial Institutions

Name (Symbol)
Mkt cap
P/E
Forward P/E
Yield
American Express (NYSE:AXP)
45.52B
25
12
1.9%
Bank of America (NYSE:BAC)
144.11B
-
8
0.2%
Bank of New York Mellon (NYSE:BK)
34.45B
-
10
1.3%
Citigroup (NYSE:C)
96.84B
-
10
-
Goldman Sachs (NYSE:GS)
84.85B
8
8
0.9%
JP Morgan Chase (NYSE:JPM)
165.45B
19
9
0.5%
MetLife (NYSE:MET)
29.80B
-
7
2.1%
Morgan Stanley (NYSE:MS)
38.34B
-
8
0.7%
U.S. Bancorp (NYSE:USB)
47.08B
26
11
0.8%
Wells Fargo (NYSE:WFC)
141.58B
15
10
0.7%
Bank Nova Scotia (NYSE:BNS)
46.56B
15
10
4.2%
Bank Of Montreal (NYSE:BMO)
29.33B
17
10
5.1%
CIBC (NYSE:CM)
25.55B
27
10
5.2%
Royal Bank Of Canada (NYSE:RY)
76.79B
24
11
3.6%
Toronto Dominion (NYSE:TD)
54.87B
20
10
3.8%

The first 10 are US major financial companies. The last 5 are Canadian banks. Most financial profits have come from trading operations. They all have very low forward P/E, but only Canadian banks pay juicy dividends.

Financial Sector Remains Volatile

Banks are likely to remain volatile in the short term on concerns about potent new regulations, sovereign risk, tight credit, high unemployment rate and continued uncertainty in the housing market. Earlier this month the rating agencies changed their outlooks on Bank of America, Citigroup, Morgan Stanley and Goldman Sachs to negative due to potential declining government support.

Loan losses are still mounting, foreclosures are rising. Borrowing short and lending long is a strategic risky business. They might be hit by the interest rate risk that often accompanies this sort of mismatch when the economy recovers.

Regional Banks Could Get Hit by a Wave of Commercial-Loan Failures

Of the roughly 8,100 U.S. banks, nearly 3,000 small U.S. banks on the front lines of small-business lending could be forced to dramatically curtail their lending because of losses on commercial real-estate loans. From 2010 to 2014, some $1.4 trillion in commercial real-estate loans are coming due. But for nearly half of those loans, the borrower's debt is more than the property value, according to The Wall Street Journal.

Comparison between US Major & Regional Banks and Canadian Banks

The table below shows major US banks have much higher debt to equity ratio than regional and Canadian banks.

Name (Symbol)
Category
Debt/Equity
Royal Bank Of Canada (RY)
Canadian
1.13
Toronto Dominion (TD)
Canadian
2.03
BB&T Corporation (NYSE:BBT)
Regional
1.82
Northern Trust (NASDAQ:NTRS)
Regional
2.29
Bank of America (BAC)
US Major
3.30
JP Morgan Chase (JPM)
US Major
4.24

10 Main Financial ETFs (by Net Assets)

Fund Name (Ticker)
Net Assets
Expense Ratio
Financial Select Sector SPDR (NYSEARCA:XLF)
5.84B
0.22%
Ultra Financials ProShares (NYSEARCA:UYG)
1.71B
0.95%
PowerShares Financial Pref (NYSEARCA:PGF)
1.51B
0.68%
Direxion Daily Financial Bull 3X (NYSEARCA:FAS)
1.15B
0.85%
SPDR KBW Bank (NYSEARCA:KBE)
725.75M
0.35%
SPDR KBW Regional Banking (NYSEARCA:KRE)
695.84M
0.35%
iShares Dow Jones US Financial (NYSEARCA:IYF)
494.03M
0.48%
Vanguard Financials ETF (NYSEARCA:VFH)
489.71M
0.25%
Regional Bank HOLDRs (NYSEARCA:RKH)
336.77M
-
iShares Dow Jones US Financial (NYSEARCA:IYG)
313.25M
0.48%

On the other hand, if you want to short the financial sector, you might use Direxion Daily Financial Bear 3X Shares (NYSEARCA:FAZ) or UltraShort Financials ProShares (NYSEARCA:SKF).

Conclusion

Warren Buffett's long-time partner Charlie Munger warns that 2012 is the tipping point on the 'road to ruin'.

From August to December 2009, U.S. equity funds suffered about $46 billion of outflows while bond funds’ inflow was $198 billion, according to ICI. Investors are nervous, but they still want to invest. People continue to look for places to put their money but many investors now have a lower risk tolerance and are interested in more secure investment vehicles.

Equity portfolios really need to look at least three years out. If you are going to need that money in the near term, it shouldn't be invested in equities. RY and TD have a very high short ratio. Nonetheless, as mentioned in my previous article, if you have a long time horizon and you want dividends from the financial sector, Canadian banks or US regional banks in areas with less exposure to residential and commercial overbuilding might be good choices.

Data are from Google and Yahoo Finance as of February 26, 2010.

Disclosure: Long BNS and TD.

Source: Canadian Banks Still Paying Juicy Dividends