Wednesday, September 21, 2011

BBT's a Bank You Can Bank On. B of A and Cirigroup, not so much

The U.S. government has invested hundreds of billions of dollars -- including the $750 billion Troubled Asset Recovery Program (TARP) -- to keep the world's biggest banks from failing -- some of those are based in the U.S. But if you're going to put your own money into bank stock, skip the ones that got bailed out -- like Bank of America (NYSE: BAC) and Citigroup (NYSE: C) and consider a stake in a profitable regional bank like BB&T (NYSE: BBT).

Banking used to be such an easy business. Bankers would roll into the office at 10am, take a few meetings, and be out on the golf course by 2pm. In between, they'd make a business or home loan and feel blissfully confident that they would get a nice solid paycheck every two weeks -- and attend a delightful Christmas party at the end of the year.

But starting in the mid-1970s that cozy world crumbled -- leading to a raft of changes that has made banking a terrible business for everyone associated with it except for a handful of traders. Here are the three most significant ruptures in the banking industry structure:
  • Deregulation. In 1975, Washington allowed competitors to get into the stock brokerage business -- enabling discount brokers to take market share away from the so-called full-service brokerage houses like Merrill Lynch -- now a B of A subsidiary. Other deregulation let Savings & Loans (S&Ls), that had previously been bastions of safety, to speculate on interest rates. And in the 1990s, the rule that kept commercial (taking deposits and lending them out) and investment banking (issuing securities and advising on mergers) separate -- passed to keep another Great Depression from happening -- was repealed. All these changes ramped up the risks that bankers could take with government-guaranteed consumer deposits.
  • Securitization. The 1980s featured the emergence of securitization -- selling financial assets like mortgages, credit card receivables, and commercial loans into a trust and then issuing securities based on the cash flows the assets generated. Securitization turned lenders into factories that mass-produced loans because the investment banks that engaged in securitization had an insatiable appetite for ever-bigger portfolios to boost their revenues and banker bonuses. As the volume of loans rose, the quality plummetted. But since ratings agencies competed to AAA-rate those dodgy loan bundles, investor around the world were eager to buy them. 
  • Technology. Up until the invention of the ATM, banks conducted business through buildings on streets in cities where their customers lived and worked. Those bank branches are much more expensive to own and operate than an ATM. And with the emergence of secure ways to pass information and money on the Internet, people can conduct many banking transactions without even leaving their home or office. This leaves banks in an uncomfortable position of operating plenty of stores when a more convenient and cost-effective delivery mechanism is available to them at the same time.
All these changes led banks to take bigger risks as they struggled not to lose market share and the resulting bonuses to their more aggressive peers. And about once a decade, those risks led to a financial crisis:
  • LDC loans. In the 1970s, there were big losses due to loans to so-called Lesser Developed Countries (LDCs);
  • Oil patch lending. In the early 1980s, there was another collapse due to too much lending for oil and gas exploration and oil-patch real estate;
  • LBOs. The 1980s ended with a collapse in loans for leveraged buyouts; and
  • Sub-prime securitization. We are still suffering the after-effects of the 2008 financial collapse that resulted from institutional investors who bought bundles of subprime-mortgage backed securities on margin.
Among the biggest perpetrators of the latest financial crisis remain two zombie banks -- B of A and Citigroup. I call them zombie banks because if they were to adjust the value of their bad loans to their true current value, those banks would end up with a negative net worth. 

B of A has $222 billion in shareholders' equity and nearly $2 trillion in so-called Level 2 and Level 3 assets -- for which there is no way to value them in the market. That $2 trillion includes $1.4 trillion in so-called derivatives that Warren Buffett called financial weapons of mass destruction.

Since B of A's financial statements do not reflect the real-time value of those Level 2 and Level 3 assets, it is possible to think about scenarios of what they're really worth. And in one such scenario, a mere 11% drop in their value -- $222 billion divided by $2 trillion -- would wipe out B of A's net worth.

Surprisingly, not all banks are walking dead. BB&T, a North Carolina commercial bank with offices in North Carolina, Virginia, Florida, Georgia, Maryland, South Carolina, Alabama, Kentucky, West Virginia, Tennessee, Nevada, Texas, Washington D.C and Indiana, is doing well and it's stock is cheap.

The $15 billion (market capitalization) BB&T had $6.9 billion in sales and earned a nice 11.3% net profit margin. And it is screamingly cheap -- trading at a Price-Earnings to Growth ratio (1.0 is fair value) of 0.43 on a P/E of 16.3 and earnings forecast to grow 38% to $2.42 in 2012 (after 51% EPS growth expected for 2011). Citigroup has $176 billion in net worth but it has mysteriously avoided reporting for those Level 2 and Level 3 assets

BB&T stuck the traditional banking business and does it well. Most investors are too gloomy to notice this booming bank whose stock is selling at a discount.


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