2 Schools of Thought on Buying Bank Stocks

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 |  Includes: KBE, RKH, XLF
by: Investment U

If you have followed the market over the past year, you know what's been happening with bank stocks.

A good proxy for the group is KBW Bank ETF (NYSEARCA:KBE), an exchange-traded fund that holds all of the nation's major banks. The fund has lost nearly half of its value over the past 13 months.

The index of smaller, regional banks - Regional Bank HOLDRS (NYSEARCA:RKH) - has fallen even more.

And some banks - even the large ones - are going down for the count. Two weeks ago, for instance, we saw the federal takeover of IndyMac, the second largest U.S. bank failure.

To some analysts, this marked the nadir for the sector. Over the past two weeks, many bank stocks shot higher, although we saw some profit taking on Thursday and Friday.

Many are asking whether this is the long-awaited turnaround that value investors have been waiting for. Or is it just a bigger-than-average dead cat bounce?

Buying Bank Stocks - 2 Schools of Thought

There are two schools of thought on whether or not now is a good time to begin buying bank stocks:

  • Analysts like James B. Stewart at Dow Jones think that bank stocks are a raging buy. In a recent article in The Wall Street Journal, he opined that "The current indiscriminate selloff in the financial sector makes no sense… This simply isn't rational."

  • And, indeed, shares of lenders have fallen so far that these stocks look attractive on an earnings, book value and yield basis.

But hold on. The first three questions any serious investor must ask are "will the earnings hold up, is the book value still valid, and will the dividend be maintained?" Three very big "ifs."

Furthermore, we should be slow to dispute the collective wisdom of the market. It's tough for any analyst to claim he knows more than the thousands of investors who are voting each day to buy or sell - and risking hundreds of millions in the process.

Stewart was right about one thing, however. He correctly predicted that, "the Treasury and the Federal Reserve aren't going to stand idly by and let the big mortgage investors, with their implicit government guarantees, become insolvent."

Bailing Out Freddie Mac (FRE) & Fannie Mae (FNM)

Uncle Sam's bailout of Freddie Mac and Fannie Mae, the wisdom of which we can debate, is in full swing. And the SEC has made it much tougher to short beaten-down financial stocks, something akin to changing the rules in the middle of the game.

However, the federal government's helping hand isn't going to fix the problems at your local bank. Or at the big money center banks, either.

Banks made mountains of loans to borrowers with poor credit ratings, hoping that the higher mortgage rates they charged would offset the higher defaults that go hand-in-hand with subprime lending.

This turned out to be a very bad bet. Soaring loan defaults have forced banks to write down the value of their loan portfolios and slash or eliminate dividends.

As analyst John Waggoner wrote recently, "If you've been around long enough, you know that things go terribly wrong in the banking industry with depressing regularity."

  • In the 1980s, many banks took enormous losses on ill-advised loans in the Texas and Oklahoma oil patch. They lost billions more lending to governments in Latin America.

  • In the 1990s, the federal government spent more than $1 trillion bailing out banks and the Savings & Loan industry due to ill-advised real estate loans.

  • And now the banks have done it again.

As a result, banking stocks' share prices have been severely punished. Is now the time to step up to the plate and take a big swing?

Not in my estimation.

Buying Bank Stocks in a Bear Market

Despite the sharp rally in bank stocks lately, this is not how bear markets in financial shares generally end. History shows that bank stocks tend to make a long, shallow bottom. Their suffering extends for months.

This time isn't likely to be any different and for one key reason: The housing decline isn't over. In the hardest hit areas in places like Florida and California, it's not just the subprime borrowers that are mailing the keys back to the bank; thousands of higher-quality borrowers are, too. Even if they can afford their payments…

What happens is this:

  • A homeowner who took out a 100% mortgage on a $500,000 property that is now worth, say, $325,000 begins asking himself why he is making payments on something that is worth a whole lot less than he paid for it.

  • Many are choosing to ruin their credit rating or declare bankruptcy rather than continuing paying on a big, depreciating asset. We can argue about the ethics of this, but the bottom line is it's happening. And the banks are bearing the brunt of it.

  • The question now is what happens to banks if the housing decline continues, as it clearly is, or even accelerates? This is the $6 million-question every buyer of U.S. bank stocks has to ask himself.

In my view, banks are NOT a screaming buy at the moment, perhaps especially after the big rally we've seen over the past two weeks.

At some point, bank stocks will be an outstanding buy. But not until the housing decline begins to ebb.

In the meantime, caveat emptor.