The Pros and Cons of Investing in Bank Stocks

Bargains or bear traps?

Closeup of the Continental Illinois Bank Building

Amanda Hall/Robert Harding World Imagery/Getty Images

The risk of investing in bank stocks should be adequately included within the share prices of these institutions, and buyers should be able to identify whether price corrections represent a buying opportunity or a bear trap.

Hearing talk about exposure to subprime borrowers is common on Wall Street. These are borrowers who have taken loans that they can't afford to repay. Maybe they bought a home that was far too expensive using an adjustable rate mortgage, or perhaps they're experiencing negative amortization. The principal balance of their loan is actually increasing each month despite their monthly payments.

This is a critical component of this type of investment.

How Banks Operate

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

The difference between what the bank pays out in interest to the depositors to keep these funds coming in and the interest income it makes on the loans it underwrote for customers is referred to as net interest income.

How an Accounting Reserve Works

The cash is paid out to the borrower and an asset for the loan is established when these loans are originated on the books. The bank then creates a company-wide reserve on its entire portfolio of loans for expected losses. They might say, “We think that 1% of all these loans will default,” so they open an accounting reserve that reduces the value of the loan on the balance sheet

A reserve is simply money set aside to cover future losses on these loans.

The bank has already created a buffer on the balance sheet to absorb the shock if these loans do, in fact, go bad. They can do this without really damaging reported earnings.

They might also view loans on an individual basis, creating a reserve when it appears that the borrower might have problems with repayment.

A Hybrid Model: Other Fees

Banks were largely dependent upon interest income in commercial banking's early days. It generated profit for the owners and it funded future expansion, but modern banks have adopted a hybrid model.

A hybrid model allows them to additionally generate upward of 50% of their profits from fees such as:

  • Merchant payments
  • Credit card processing
  • Bank trust departments
  • Mutual funds
  • Insurance brokerage
  • Annuities
  • Overdraft charges

These factors should be weighed when deciding on investing as well.

Bank Stock Crisis or Distraction?

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

Adverse economic conditions can cause serious concern for bank investors. A lot of fee income can be generated from mortgage originations, and fewer home sales means less fee income.

Big-name investors, including Warren Buffett, sometimes invest in shares of a few select banks regardless.

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 improved if the stock is held in a tax-advantaged account such as a Roth or traditional IRA. You can take a tax deduction for contributions made to a traditional IRA, and you can take tax-free withdrawals from a Roth IRA in many cases if you're over age 59½. In either case, you'll have added benefits beyond your investment returns.

Simply put in the assumptions, the cash dividend yield, and your estimate of the adequacy of the loss reserves. Compare the loss reserves for comparable banks. Anything way out of line should be cause for concern.

The Balance does not provide tax, investment, or financial services, and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.