Wednesday, July 22, 2009
It is not surprising to see U.S. Bancorp, or in fact, any other bank facing losses due to defaults, foreclosures, late payments, and so on. During the first quarter of 2009, investors feared that the U.S. Government was going to nationalize the banks. Since this did not happen, many banks, including U.S. Bancorp, saw their stock prices appreciate significantly.
The problems that banks face are far from being over, but can U.S. Bancorp survive and earn itself out of trouble? Before answering this question, let’s talk about banking in general.
The Banking Industry
Banks are highly leveraged institutions: for every $100 in assets, $90 is borrowed from depositors or other lenders and only $10 is in the form of equity. Being leveraged so much makes banks vulnerable to economic downturns. Because of very thin margins, one bad loan may wipe out the profits of several good loans. A poorly managed bank can destroy shareholders’ wealth quickly. This was perfectly demonstrated by Citigroup, Inc.
U.S. Bancorp has a reputation of being one of the most conservative banks in the industry. The bank was not involved in loaning money to the risky borrowers that other banks loaned. Instead, it followed strict underwriting criteria that kept it from getting into problems that other banks now face. But even though it was more conservative, it saw an increase in delinquencies, foreclosures, and write-offs. As unemployment kept getting worse, even the best borrowers defaulted.
Another important point that makes U.S. Bancorp different from other banks is the diversified nature of its business. The company operates in four separate business segments: consumer banking, wholesale banking, payment services, and wealth management & securities services. Consumer and wholesale banking contributed 60 percent of revenue. Payment services, and wealth management & securities services, contributed 27 percent and 13 percent, respectively. This diversification is important to point out that the non-banking segments can be used to offset losses from banking operations.
Some investors might argue losses are still going up and U.S. Bancorp is not even close to being on its way up. While this is true, the losses are mainly from loans made in the past. Nonperforming loans will finally get written off, meaning they will be taken off the balance sheet, and the collateral will be taken and sold off by the bank. It is just a matter of time before losses start trending down because the new loans are underwritten with even more care than ever before. Despite all the losses, the bank is still profitable. It just generates less profit than before.
The reason why the stock is trading at around $19 is because the majority of investors are not able to sleep at night knowing that the price could decline. Most mutual funds or hedge funds are afraid to acquire the stock because it is unlikely to show short-term gains which could lead to losing clients.
The stock is cheap because there is short-term uncertainty. Once the uncertainty is gone, the $19 price tag will be history.
Disclosure: Long USB at the time of this article.