Waiting for the Banks to Bottom

• ByTim Melvin, RealMoney.com Contributor
• On 9:50 am EDT, Tuesday September 15, 2009

I make no secret of the fact that I am waiting not so very patiently for the chance to be over-invested in small bank stocks. The last time we had a banking crisis in this country, small bank stocks fell to ridiculous valuations, and the next five years were profitable and an enormous amount of fun.

It was a great time to be a value investor. I was happily buying bank stocks at half of book and selling them in a takeover a few years later at multiples of tangible book value that eventually reached a level of three times at the height of the merger wave. I think it will be the same in the aftermath of the current bank meltdown.

But the time to buy is not here yet. I offer no opinion on the short-term trading of bank stocks, especially the larger ones. That is not what I do, and I cannot offer you any particular insight on that type of trading. However, as a long-term value investor, I can tell you that small banks have not bottomed. Until the value of the underlying collateral of the loan portfolios stabilizes, their earnings and balance sheets remain threatened.

The collateral on the vast majority of these loans is real estate. Real estate is not at a bottom, in my opinion. There are just too many problems facing the market for prices to bottom. We have talked about the two most obvious: Foreclosures and unemployment are both still rising, and they are a serious threat to the housing market. We are seeing sings of continued deterioration at the high end of the market even on A-rated loans. Yes, there have been some signs of improvement on the low end, but when it comes to housing prices, "less bad" is not "good." We have a ways to go to get there, in my opinion.

There are a few other problems that face the small bank stocks. The first of these has to do with option-ARM loans and their effect on real estate prices. According to Fitch, 88% of the outstanding option-ARM loans have not yet experienced a reset event. An astonishing 94% of those borrowers are making the minimum option payment.

In spite of this, 46% of these loans are at least 30 days delinquent even though only 12% of them have experienced the payment shock of a reset even. The combination of minimum payments and falling home values has taken average loan-to-value from 79% at origination to 126% today. A lot of these homes are going to come onto the market as distressed foreclosure sales as the combination of payment shock and negative equity forces homeowners to just hand over the keys. There is no prospect of a workout, since many cannot even begin to afford the real payments on the home.

Banks face another significant threat for the next couple of years. The FDIC fund is stretched to its limits. At the end of the quarter, the FDIC's insurance fund had about $10 billion left after the wave of failures in the first half of the year. Since the start of the current quarter, there have been 39 more bank failures, and the estimated losses pretty much eat up the balance.

The FDIC needs to raise $54 billion to get back to the mandated 1.15% of insured deposits, and it only has two choices. One is to borrow it from the Treasury under the borrowing authority granted in recent legislation. But Shelia Blair opposes that option, and it is a little vague how the FDIC would ever be able to repay the money.

The second choice is an assessment on banks of 5 basis points a quarter of assets minus Tier 1 capital. That would amount to 20 basis points of tax levied on the banks a year. That tax is on total assets, not on tangible equity. Raising the $54 billion needed to meet the 1.15% mandated level would require fees that add up to right around 25% of tangible equity. That represents a huge hit to earnings, especially at the smaller institutions.

Right now we have a situation in small bank stocks where the cheap ones are not healthy enough and the healthy ones are not yet cheap enough. We are getting there. I see banks I am anxious to buy, such as Shore Bancshares here on the Eastern Shore of Maryland and Towne Bank in Southeastern Virginia, approaching the cheap-enough-to-buy levels. I think after the next collateral shock and subsequent capital raise, we will be at the levels needed to back up the truck on these stocks.

If nothing else, following the small bank stocks is teaching me the virtue and hopefully the profitability of patience.

Buzz up!