Are bank stocks worth the risk?

“If bank stocks are the best investments you can find for your portfolio, you should fear for you wealth.” Value Investment Institute, March 2011

Pretty strong words. I came across this commentary on banks from the Value Investment Institute and it prompted me to write this post on the suitability of banks for income investors. It’s a great and short read. First, lets look at why the authors are so negative on banks. It comes down to the primary risk management principal, preservation of capital. If the risk of capital loss from an investment is inordinately high then no other factor, like income, matters at all. Quoting from the piece;

Banks don’t make any profits… In the book, Fooled By Randomness, Taleb describes the Latin American debt crisis in the early 1980s, which cost large US commercial banks more than the cumulative profits they had ever made up to then. This was shortly followed by the US Savings & Loans crisis, which lasted from the mid-­‐80s and into the 1990s, when an extraordinary 750 institutions failed (at an estimated cost of $90bn). It’s a similar story in Asia. Between 1980 and 2002, 14 banking crises cost on average 22% of GDP (the 1997 crisis cost Indonesia a whopping 55% of GDP). And again during the recent Global financial crisis, which the IMF estimated cost $2.3trn, a figure that would undoubtedly have been many times higher if not for the dramatic and unprecedented actions of global Central Banks. While no one can be certain of what the future holds, it would be very surprising if such events do not repeat themselves in the future  the weight of historical evidence would suggest so.

So, you’re going along nicely invested in your bank stocks, collecting presumably safe dividends, then every so often, 10-20 years, or more often recently, bam, a new banking crises. Bank stocks crash, many get wiped out along with their shareholders and the cycle resets. This basically happens because of excessive risk taking by banks and too much leverage. The example they use in the piece is of Barclays bank, one of the survivors of the financial crisis. It’s balance sheet is leveraged 26 times its equity which means a 4% drop in the value of their assets would wipe out all the shareholder equity. Some margin of safety…

The investment banks are the worst in terms of leverage. A bit closer to home, the investment banks like Goldman and Morgan Stanley are leveraged way more than the more conservative banks like Wells Fargo and US Bank. But even those so called conservative banks are leveraged 10-11x. See link here for Wells. When times get tough as they inevitably do every so often that amount of leverage is a killer. Then there is the fact that bank balance sheets are nearly impossible to understand and many of their investments are off balance sheet. But maybe the worst thing is that bank portfolios do not have to be marked to market. So, you really don’t know what their assets are worth. I find it amazing that in such an environment most investors and advisers think mortgage REITs are riskier than banks. Most mortgage REITs are less leveraged than banks and they are required to mark their portfolios to market every quarter. But that’s a topic for another post.

On the income side the story is just as grim for banks. Lets look at a diversified portfolio. What was the effect on your income stream? Taking a look at the S&P500 financial sector index (XLF) dividend distributions, the 2007 dividend was $0.8689 and the 2010 distribution was $0.1565, a drop of 82% over a 3 year period. Even in a stalwart bank like Wells Fargo your dividend went from $1.30 in 2008 to $0.20 in 2010. This exposes yet another problem with relying on indexes like the S&P500. Financials make up a large portion of the index, since they represent a large portion of the economy, currently about 20% of the S&P500. A big reduction in bank dividends obviously affects the index as well. I wonder how much of the decline in dividends in the S&P500 during the financial crisis was due to financials. I  haven’t been able to find this data.

In summary, I think bank stocks are too risky for most income investors, in particular for retirees living off their income. This risk of principal loss and the risk of dividend reductions are just to great. That’s not to say there is not money to made investing in banks but an investor needs to be very vigilant, watch the leverage ratios, and be able to get out before the next banking crises. There will be one for sure. There always has been.