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The ‘Great Recession’ led many investors to abandon the financial sector as dividends became either miniscule or non-existent among the big banks, growth disappeared for the small community banks, and losses piled up for the entire group due to the massive amounts of toxic assets on everyone’s books.

J.P. Morgan (JPM) came out last week and posted strong numbers (see earnings call transcript here), which gave the financials another boost, after an already strong two months of returns for investors. Earnings were helped in part by lower loan losses and the company releasing loan loss reserves. Everything seems rosy for investors, however, we would continue to be wary of the nascent recovery in the financial sector.

A closer look at the industry itself indicates to us that there may be problems ahead for all financials. We are not predicting Armageddon, however, these are things we constantly are on the lookout for. Although the ‘Too Big to Fail’ group of banks has only gotten bigger in size and healthier over time, the small community banks, the lifeblood of credit for small businesses and builders, are becoming zombie banks. They cannot raise new capital, are under a cloud of suspicion from the market (rightfully so in most cases), and are constantly seeing regulations that make it almost impossible to compete against the ‘Too Big to Fail’ banks. When the credit crisis hit, many of the small banks saw deposits leave to the bigger banks, over fears of liquidity at small banks. This was most pronounced in small towns with community banks as people began to worry about their deposit limit risk at these institutions.

Now the various bank regulators are going into the small community banks and forcing them to take a hard look at their loans and re-categorize them. Loans that are currently being worked out between the bank and its borrowers, where interest is only being paid, are going to have to be called in as they mature (i.e., the extend and pretend practice). This has not been a material amount to the big banks, and thus, our guess as to why there is no disclosure. However, for the small banks, this is a real problem. The regulators may be signing these small banks’ death certificates, forcing them to effectively put their borrowers in default.

We have to agree that having a loan not amortize is an issue, however, when the bank is still getting its interest payments, that is beneficial to the system as they get to book that as profit and thus provide a cushion for any future losses. Most importantly, it keeps the economy running and people from losing their jobs. This in-and-of-itself could cause serious problems for the system as a whole if regulators continue to insist the banks try and force their customers to pay once the loan expires instead of working out of the loans as they currently are. Our mentor always said that, “a credit crisis is the scariest thing, because no one can expect to get a call one day and pay off all of their debt, as their creditor demands, the very next,” which is why cash hoarding begins.

We would encourage investors holding shares in the small community banks to read those entities’ 10-Qs, 8-Ks and all other financial information to see how big of an issue this is. Almost all of the community banks we follow in our region have these issues specifically stated. Many investors believe that the small community banks give them the best leverage for a recovery and will provide the best returns once the market corrects itself. We would disagree, and instead direct their attention to the big diversified financials.

For those who either insist on being invested in financials despite the still lingering issues, or have to be invested in them for allocation purposes, we would recommend the following companies:

If one truly believes that the real estate issues are behind us and financials are going higher, J.P. Morgan is best of breed. As they slowly work off the problem loans from Washington Mutual they took on and streamline operations between the J.P. Morgan, WaMu and Bear Stearns properties, earnings will further improve. Earnings this quarter were impressive, a nearly 50% increase in 4th Quarter profits on revenue growth in the double digits, all the while blowing away analysts’ expectations.

Offering the most leverage to a real estate recovery, in our opinion, is Bank of America (BAC). It is a bank with offices across the United States and a huge mortgage portfolio from its acquisition of Countrywide Financial. They have one of the largest deposit bases in the country and one of the largest customer bases to go along with it, which, with the new fee systems being implemented, should only add to profits. The bank is currently doing a good job of getting Merrill Lynch involved in their marketing blitz. They have begun to include it on their website to enroll current banking customers into their brokerage business as well. We also believe that going forward, the bank will also be able to realize further profits on their lending at Merrill Lynch as that entity will be able to tap into BofA’s cheap deposits.

Our third play leveraged to the real estate market would be one of Warren Buffett’s favorite financials: Wells Fargo (WFC). The company now has a national presence via their Wells Fargo brand out west and the Wachovia brand in the east. Already, the company has combined the brokerage businesses together, however, soon the company will have a national identity across all of their business, most notably, the retail banking unit. The Wachovia acquisition increased Wells Fargo’s exposure to mortgages, including the highly risky type. The company surprised us with its ability to navigate through the financial crisis, and we firmly believe that should real estate prices rebound along with the economy continuing its steady recovery, Wells Fargo could be one of the leaders.

These three banks should steal business from the community banks going forward as the smaller banks will be nearly paralyzed from growing their brands and portfolios any further. The community banks are taking on that zombie bank status that everyone has feared, while the big boys now have plenty of firepower moving forward to increase business.

The risks inherent in investing in the community bank sector force us to want to de-risk the trade. The large diversified financials offer the best exposure to continued recovery for the financials while also limiting downside risk. Also, the dividends going forward will also increase investors’ total returns. For all of these reasons we find the ‘Too Big to Fail’ entities of the world much more compelling investments at this time.

Source: If You Must Invest in Financials, Be Sure to Choose 'Too Big to Fail'