Beware of the Banking Sector

Includes: KBE, KRE, RKH, XLF
by: Tony Abbate, CFA

Successful investing is all about risk and reward. My ‘rule of thumb’ is to purchase investments where the upside is at least three times as much as the downside. Given the huge increase we have seen in bank share prices over the past year and the continued deteriorating fundamentals in mortgage default rates, I believe bank stocks do not offer an attractive risk/reward trade-off at this time.

I think the odds are high that in second quarter we will reach a turning point where bank stocks will start to underperform the market. Here are my reasons why:

First, over the next few weeks we are going to see an unwinding of a number of programs put in place by the government to help support housing prices and the banking sector. On April 1st the Fed ends its purchase program of Mortgage Backed Securities. On May 1st, unless extended, the $8,000 tax credit for new home buyers and homebuyers who buy a larger house will expire. I think this ‘one-two punch’ will be too much to handle for housing prices and the banking sector.

Second, we are entering a two year stage of a surge in interest rates associated with adjustable rate mortgages. There will be a peak of about $30 billion in mortgage resets in the third quarter of this year. After a brief respite in the 1st quarter of 2011, we will see a surge in the middle of 2011 as $40 billion worth of mortgages are projected to reset. In the middle of 2012 we will see mortgage resets plummet to about $2.5 billion. (The data I reference is from Credit Suisse (NYSE:CS).)

Third, I think the odds are greater than 50/50 housing prices will continue their decline. I base this on the fact that on a historical basis, median housing prices relative to median family incomes are still quite high. Prior to 2000, before the Federal Reserve recklessly lowered interest rates to combat the tech bubble fallout, the median house price sold at 3.2 times the median family income.

At the end of 2009 the ratio was 3.4. The range between 1968 and 1999 was 2.7 to 3.5. I think the housing market will bottom at a housing price to income ratio of 2.7 to 3.1. (History has shown that bursting bubbles tend to overshoot on downside.) This puts my estimate of the potential decrease in housing prices, through the end of 2011, to a decline between 8.8% and 20.6%.

Fourth, the commercial real estate market is slowly starting to crumble. With decreasing occupancy rates, higher rates of unemployment and the high amount of leverage in this space, I think we are on the cusp of a decline in commercial real estate prices. This has the potential to create havoc on the banks’ balance sheets.

Fifth, the FDIC increased its annual budget for 2010 to $4 billion from 2.6 billion in 2009. The money was budgeted to add 1,600 staffers and deal with the expected increase in bank failures. I think the Feds know something that perhaps the market has not discounted.

I do not own any bank stocks for myself or my clients. I do not think they present a favorable risk-reward scenario. If you are to own bank stocks, as the sign at the beach says without a lifeguard on duty, “Swim At Your Own Risk”.

Disclosure: Neither the author nor his clients own shares in bank stocks.