Peter Mycroft Psaras'  Instablog

 
The following is an analysis of the four largest banks in the United States.  The four banks analyzed represent 5.17% of the S&P 500 Index and play a major role in both the USA and Global economies.

The following charts will show the combined results for all four banks in order to gauge the health of the banking sector when compared over a 12 year time frame.  By taking a long view we can determine how healthy they are as a group over a variety of business cycles.

The first thing I always look for as an Analyst is the long term debt picture for any company I analyze.  I like to see long term debt coming down over the years as a sign of fiscal responsibility by management.  Whether we are talking about an individual or a company, how one manages their credit determines how they are to be judged.  By looking at the chart below one can clearly see that the four banks are borrowing money hand over fist and that is not a promising sign.

The group has increased their debt 774% over the last 12 years (including estimates for 2009 and 2010) or at an annualized compounded rate of 19.80%.  That is pretty scary when you think about it. If you as an individual had $10,000 in credit card bills in 1999 and increased your borrowing at the same rate you would end up in 2010 with total credit card bills equal to $87,394.04 and would be in trouble.

But then again it is all relative to your income. If in 1999 you were making $50,000 and now you are making $200,000 a year your credit card situation, though still a problem, can be eliminated in just a few years with some fiscal responsibility.  But if your salary only went up to $70,000 during that time, then you are in a much worse situation then you were in 1999 by a large margin.

Let’s see the long term picture for the group in reference to their net profits.

As you can see their Long Term Borrowing went up 774% but their Net Income went up only 55% during that time, so this is not a good sign.  But then again these are banks and they borrow the money for next to nothing from the government and then loan it out to customers for a nice spread.  They also loan out customer deposits, which they pay little or no interest on and loan out the money at 5%+.  So let’s see how the group is doing on the loan front.

So they borrowed $1.375 Trillion and have loaned out $3.165 Trillion, so why are they not making the huge profits similar to what they were making in 2004-2006?  Well it’s called bad loans and their customers are having problems paying them back.  This can clearly be seen in the following chart.

Nothing eats away at a bank’s profits more than loan loss provisions.  This is a clear sign that they have a lot of bad loans on their books, which they will probably have to eat.  The above chart represents the percent of loan loss provisions to loans but here are the actual dollar figures.

So as you can see it is pretty hard to make money when you have to keep $136 Billion on the side to cover your bad loans.  This is the key measure to look for when judging banks as when they see little need for loan loss reserves, then all that money will eventually go to the bottom line and that will result in huge profits being made.  This is also a clear sign that the Federal Reserve cannot raise interest rates until these banks get their books in order.  The interest payments on $1.375 trillion in debt goes up big time for every quarter point the Fed raises. So the Fed is held hostage and can't move as we will spiral down again if they do.

Now let's see how the shareholders in these banks are doing on an ownership front?  The following chart shows that they have not only lost money when their stock market prices tanked, but that their percentage ownership has been cut as the group has increased their shares outstanding (and not because of any stocks split).

This clearly shows that the banks used their shares as currency to buy the Washington Mutual’s, Merrill Lynch’s and Wachovia’s of the world and also issued new shares to get their hands on some much needed cash to stay afloat.  Now the best time to use your stock for currency is when your stock is overvalued and the stock you are buying is undervalued.  The worst time to do it is when your stock price is low and you’re buying something that is selling at a premium to its current condition. 

The jury is still out on whether these purchases. that these four banks made, where good investments or not.  If you look at the combined shareholders equity of the banks you will see that they may have gotten some value out of these purchases.

The numbers above maybe real or they maybe fiction and we cannot really know as we don’t know what assets are on the companies’ books and what those assets are really worth.  Are they full of illiquid REIT’s, who are full of empty commercial properties and who are quoted at $10 in Annual reports, but can only be sold for $4 in the secondary market?  How much of this stuff is fluff or the real numbers we will never know and having said that I don’t put much faith in the banks book values just as I don’t put much faith in intangibles when analyzing tech stocks. 

The way I analyze a bank is by its Return on Invested Capital (ROIC).  In other words, how much return am I going to get in profits for every $1 of invested capital that is employed?  Total Capital is just Shareholders Equity + Long Term Debt, so since we have both numbers let’s put up a chart.

As you can see from the chart above that Total Capital has gone from $297 Billion in 1999 to $2.079 Trillion estimated for 2010. That’s a lot of money and is very impressive, but then again we need to go back to the rule that I judge all companies by.  “How much profit are you going to make me for every dollar of Capital that you are going to employ?”  I don’t care if you make buggy whips or ice cream cones, every company can be judged by this parameter on an equal basis.  So though the number is impressive I want to see at least 20% ROIC (Return on Invested Capital) before I even think about investing a dime in any enterprise, whether that be on Main Street or Wall Street.  Here is a chart to show that I won’t be investing in this group anytime soon.

As you can see from these dismal numbers that the equity they have on their books is non producing and that they have borrowed way too much money as it is easy to get.  If you want to fix the banking industry, limit the amount of money that banks can loan out to their customer deposits. 

The customer deposits for all four banks are quite substantial and there is no need for these banks to borrow such excessive amounts.

Customer Deposits per bank as of 6/30/2009

Bank of America = $970,742,000,000

Citigroup = $ 804,736,000,000

Wells Fargo = $813,735,000,000

J.P. Morgan Chase = $866,477,000,000

So as you can see, without borrowing a dime from anyone they could make a nice profit from just loaning out their customer deposits in which they loan out money at 5% and pay .25%-1% in interest.

We need to get back to the old way of banking and require that homebuyers put 20% down and that Fannie Mae and Freddie Mac be put out of business.  Banks should hold onto their loans and not sell them as securitized packages.  The old way of banking works best and that’s where we need to get back to!

Disclosure: No position in WFC, BAC, C, JPM

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice.

 It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.