The Pros and Cons of Investing in Bank Stocks

Bargains or bear traps?

Investing in Bank Stocks

Amanda Hall/Robert Harding World Imagery/Getty Images

On Wall Street, hearing talk about exposure to subprime borrowers is common. Subprime borrowers are those who have taken loans that they cannot afford to repay.

Maybe they bought a home that was far too expensive using an adjustable rate mortgage, or perhaps they are experiencing negative amortization where, despite their monthly payments, the principal balance of their loan actually increases each month.

Are the risks to this exposure adequately included within the share prices of these institutions, and do price corrections in bank stocks represent a buying opportunity or a bear trap?

How Banks Operate

A bank takes in deposits from customers who establish certificates of deposit, checking accounts, savings, accounts, and other products. It then lends these funds to people who apply for mortgages, business loans, construction loans, and many other projects.

The difference between what the bank pays out to the depositors to keep the funds coming in (interest expense) and the interest it makes on the loans it underwrote for customers (interest income) is called net interest income.

In commercial banking's early days, banks were largely dependent upon interest income to generate profit for the owners and fund future expansion, but modern banks have a hybrid model that allows them to generate upwards of 50 percent of their profits from fees such as merchant payments, credit card processing, bank trust departments, mutual funds, insurance brokerage, annuities, overdraft charges, and almost anything else you can imagine.

When the loans are originated on the books, the cash is paid out to the borrower and an asset for the loan is established. The bank will then create a company-wide reserve on its entire portfolio of loans for expected losses. For example, they may say, “We think that 1 percent of all loans will default,” so they’ll open an accounting reserve that reduces the value of the loan on the balance sheet

Later, if these loans do in fact go bad, the banks have already created the buffer on the balance sheet to absorb the shock without really damaging reported earnings. In addition, they may view loans on an individual basis, creating a reserve when it appears that the borrower may have problems repaying the loan.

Bank Stock Crisis or Distraction?

Adequate reserves are extremely important for maintaining a healthy bank. If, for example, 4 percent of loans were to go bad instead of the 1 percent for which management had reserved, the results could be devastating to shareholders, wiping out an enormous portion of the book value and causing huge losses on the income statement.

Various economic conditions, especially those in the housing market, can cause concern for bank investors (a lot of fee income can be generated from mortgage originations; fewer home sales equals less fee income.) Yet big-name investors, including Warren Buffett, sometimes invest in shares of a few select banks.

Bank Stocks: It’s All About Loan Quality

Whether bank stocks are a good buy largely comes down to the quality of the underlying loans in a bank’s portfolio. As one great investment giant said, it’s difficult to get a lot of eager young men and women who can instantly manufacture earnings with the wave of a pen to contain themselves when the economy is running strong and every loan looks good.

Your probability of better than average returns on bank stocks is further improved if the stock is held in a tax-advantaged account such as a Roth IRA, traditional IRA, or others. This question can be asked for any bank: simply put in the assumptions, the cash dividend yield, and your estimate of the adequacy of the loss reserves. If you don’t know where to begin, compare the loss reserves for comparable banks; anything way out of line should be cause for concern.