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Buy when there’s blood on the street is the mantra of the true contrarian investor. So on that note, shouldn’t we be buying US bank stocks? Could bank stocks be a good five-year play?

That’s what contrarian investor, Warren Buffett, is telling the world to do. He’s advising investors to forget about the headlines and to think about how these banks will be performing in five years’ time, according to a report on CNN.

Global bank stocks are currently trading at 40-year lows. US, European and UK banks have been pummelled due to weak lending, low interest rates, regulatory pressure, bad debts, and the fallout from the European sovereign crisis.

The US financials sector is down over 20% this year; Bank of America is down 36%, Citigroup is 18% lower, Goldman Sachs has dropped 29%, and Morgan Stanley fell 22%. By historical standards, these banks are trading extremely cheaply – but these are not ordinary times. We are in the throes of a global banking crisis.

Many European banks are looking down the path of recapitalisation, asset sales and drastic cost reductions involving sacking thousands of staff worldwide. Some UK banks are trading at historic lows as the threat of nationalisation hangs heavily over the sector. RBS and Lloyds are already part nationalised.

The big risk is catching falling knives – you jump on, only to see the share price plummet further. Some bank stocks are cheap because they will go broke, get sold off, or nationalised. Dismal lending conditions, ongoing economic uncertainty and higher regulatory burdens on banks could force some firms to pull out of countries, markets or close altogether.

But when you see some banks trading at levels hardly imaginable five years ago the contrarian investor in us wants to delve deeper. Is there value for the long haul?

The strategy for investors is to locate the stocks that will survive and prosper from this current crisis. And yes, there will be winners out of this. Some banks will bolster market share as others founder. Many US banks will benefit from a shrinking European banking sector, and China banks, too, will no doubt do well – and not just out of China.

A new dawn for banks

Interestingly, six Chinese banks including the Bank of China, China Construction Bank, CICC and ICBC have set up shop in London’s business district with plans to hire hundreds of investment bankers. And since China owns four out of the seven largest banks in the world, these banks are goliaths. State-controlled China banks have deep pockets, long timeframes and clear objectives – they also enjoy almost complete market share in their home turf where a paltry 1.7% of the financial services market is shared with international firms. The impact of China investment banks on Europe, the UK and the US will be interesting to say the least; never before have the old boys had to compete with the likes of China.  

Only the strongest will survive

To survive, and then compete in this new world order banks must exhibit high tangible book values, strong balance sheets represented by deposit and loan growth, capital strength and improving credit quality. You’d also want to pinpoint the banks with the political firepower to profit from the crisis.

US banks are certainly backing themselves by buying back their own shares at a rate of knots – Goldman Sachs bought back $2.16 billion worth of its own stock in the third quarter, while JP Morgan spent $4.4 billion buying  its own stock. The banks are keen to buy shares when they’re trading at such a discount to book value. They’d be spending more if they could, however the amount they can buy back is limited by federal regulators. ‘I know that some day we are going to look back and wish we had bought back more at this price,’ Goldman Sachs CFO David Viniar said earlier this month.

Earnings are propped up

US earnings season is here giving investors a chance to pick through the debris for standout bank stocks. Impressive earnings reports have been delivered by the likes of Bank of America. However, according to Reuters many global banks – including Goldman Sachs, Morgan Stanley, Bank of America, HSBC and Barclays- are prettying up their earnings figures with controversial accounting methods. Effectively, earnings are bolstered artificially, or losses are covered up.

“In the case of JPMorgan and Citigroup, a weakening of the banks’ debt relative to U.S. Treasuries is what has led to these reported gains,” reports Reuters. “As their debt lost value, it became cheaper for the banks to retire the debt if they chose to do so. The chance to retire debt at a price below its issue price produced the gain Citi and JPMorgan are reporting, and the boost to reported earnings.”

“The rule makes it harder to compare companies because banks have wide discretion on how they apply it. They can use it on financial liabilities with some exceptions, including deposit liabilities or deferred tax liabilities. Or they can use it only for certain individual instruments, and not for others. It’s a degree of latitude that makes it difficult to compare one bank with another and to predict how big an impact it will have on a bank prior to its reported earnings,” Reuters continues.

The derivatives explosion

There’s another risk that US banks face that aren’t properly reflected in their financial statements – and aren’t really spoken about on US talkshows for fear of scaring the hell out of its citizens, and that’s derivatives risk.  The value of derivatives in the world far exceeds the total gross domestic product worldwide. The numbers are absolutely staggering.

If you’ve got the time, the following report by the Comptroller of the Currency Administrator of National Banks offers a glimpse into the magnitude of derivatives exposure held by the largest US banks – and the top four US banks hold a disproportionate about of risk; the banks are JPMorgan, Citibank, Bank of America and Goldman Sachs. Just to get a feel for this market, here are some figures.

– The notional amount of derivatives held by insured U.S. commercial banks is $249 trillion.

– The five large commercial banks represent 96% of the total banking industry notional amounts.

– JP Morgan holds $78 trillion in exposure, followed by Citi with $56 trillion, Bank of America with $53 trillion and Goldman with $48 trillion.

The largest US banks have been racheting up derivatives risk as the global banking crisis unfolds. According to the report, the notional amount held by insured U.S. commercial banks increased $5.3 trillion, or 2.2%, from the first quarter of 2011 to $249 trillion. Notional derivatives are 11.6% higher than a year ago.

If you’re thinking about buying US banks in this crisis as a contrarian play you’ve got to be aware of all the risks you face – and as we all remember not too fondly, derivatives exposure was what took out Bear Stearns in 2008.

These stocks are cheap for a reason. The trick is to find the ones that won’t be cheap in years to come. With the Aussie dollar near all-time highs against the greenback this may mark a once-in-a-lifetime opportunity for Australians to profit from beaten down US banks.

The US banks listed below are not recommendations to buy, but are simply a starting point to conduct more research of your own. The website americanbanker.com, which has a wealth of information on bank rankings, is a good place to kick off your research.

Citigroup – $34.16

Global financial services giant Citigroup, Inc. is trading far below analysts’ estimates with 22 US brokers placing a price target of $44, and a high target of $55 on the stock. Below is a 2 year price chart of Citigroup.

Wells Fargo & Company – $27.08

Wells Fargo is a retail and commercial bank largely operating out of the United States. The company is trading below analyst estimates. 29 US brokers have a median price target of $32 and a high target of $41 on the bank.

JPMorgan Chase & Co – $36.69

JPMorgan is a global investment bank. 30 brokers have a median price target of $47 and a high target of $58.

State Street – $42.01

State Street Corporation is a worldwide financial services company most known for its exchange traded products. 21 US brokers have a median price target of $47 and a high target of $57.

The Bank of New York Mellon Corporation – $22.41

The Bank of New York Mellon Corporation operates worldwide. 21 brokers have a median price target of $26 and a high target of $33.

 

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