Until today I thought Meredith Whitney of Oppenheimer was the most negative observer of banks. That was, until I read the transcript of federal reserve Vice Chairman Donald Kohn's report to the Senate committee on Banking , Housing and urban Affairs. Kohn was there to report on the health of the industry since it falls under the fed's responsibilities to oversee the United sates banking system They also have primary supervisory responsibility over any state banks that choose to join the Federal Reserve system, that is to say, most of them.
According to the Vice Chairman, conditions are not so good for the banking industry. Led by credit losses in residential real estate portfolios and sharp markdowns in securitized loan products, the banking industry suffered losses of $8 billion in the fourth quarter of 2007. Interestingly, the 50 largest banks lost a total of $9 billion. This would seem to underpin my theory that the smaller banks are not quite as bad as their more free wheeling cousins in the big cities. In the first quarter the industry was profitable earning a total of $10 billion. Although the largest 50 contributed slightly over half of the earnings, seven of them continued to struggle and reported large losses. Again, it would seem that the larger banks that ventured into sophisticated loan and investment products suffered far more than small town banks in the quarter. Indeed Kohn testified that the larger institutions continue to have problems with loan portfolios, especially real estate development loans and home equity lines of credit. As a result of this continued weakness, non performing assets for US banks better than doubled in the quarter to $81 billion. This is the highest level of troubled assets since 2002. Loan loss provisions jumped in the quarter as well to $32 billion while loan charges offs totaled $14 billion.

Kohn also stated that the industry will probably have to continue raising capital to bolster beleaguered balance sheets. So far in 2008 Bank holding companies have raised over $80 billion of new capital. Some of this, Kohn admitted, was at the urging of banking supervisors and regulators. He pointed out the the growth in nonperforming assets was far outpacing the growth of reserves to protect against those losses. Combined with what the Fed Vice Chairman expects to be a very weak earnings environment for banks, future dividend cuts and capital infusions will be needed. In his words, the Fed is urging bank holding companies to bolster their financial positions.

State banks were in much better shape than their larger brethren. The state banks reported net earrings of about $3.7 billion in the first quarter and had a return on assets of about 1%. 98% of all state banks had risk based capital ratios that met or exceeded the regulatory definition of well capitalized. However, they did escape the troubled real estate markets entirely. Non performing asset ratios for the group better than doubled in the quarter to reach the highest level since 1993/ Loan loss provisions climbed as well and are now at 1.14% of average loans at state banks. The losses are primarily the result of the weak real estate markets across the United States.

Vice Chairman Kohn's outlook was less than rosy for the banking industry going forward. He expects continued declines in the real estate markets to continue to cause growing loan losses. He further warns that if the economy continues to weaken the losses could spread to credit card and consumer lending. He warned Senators that if liquidity and capital market conditions do not improve the number of banks that do not meet satisfactory capital ratios will increase from the low levels of the past few years.

He also discussed what the fed was doing to improve supervisory procedures over the nations banking system. This is a lot like locking the door behind the burglar in my opinion. What he did do, however, was set the ground work for additional regulations for the banking system. The impact of new regulations on the industry will be interesting to observe ion the months ahead. If we had enforced the regulations on the books and the fed had done its job, I doubt we would have gotten this deep into a financial crisis. I have yet to see an instance where increased regulation increased profits for any industry.

Where does this leave us? It is simple really. For right now avoid bank stocks. They have too many issues still in front of them. There will be further losses and their balance sheets are still weak. Many of them will have to raise capital, diluting the equity of existing shareholders. The bargains that do emerge in the banking industry will far away from Wall Street and outside the beltway. The smaller banks will have problems with real estate loans but it is much easier to recover loan losses form real property than an alphabet soup of securitized paper. Small banks with high capital ratios, high equity to asset ratios and adequate loan loss provisions can be profit machines. We are starting to get an opportunity to buy these at less than tangible book value. For patient investors, this will be better than the internet boom with a fraction of the risk!

I make no secret that I think the profits in bank stocks going forward will be in the smaller banks. The large banks seem to have all got caught up in the subprime and exotic securities business trying to squeeze out every possible dollar of profit. Those chickens have come to roost in he past nine months and large banks have had literally billions of dollars of asset write offs and credit losses. They have collectively had to raise about $100 billion to repair and support their balance sheets. Small banks may have some problems in the difficult real estate markets and weak economy but they are nowhere near those of their larger competitors.

A prime example of this is one of my favorite small banks, Severn Savings bank (SVBI) is a small federal savings bank located in Annapolis, Maryland. The company has three divisions, the bank itself, Hyatt real Estate which operates as commercial real estate broker and investor, and SBI Mortgage. In the first quarter the bank did reveal that they were facing difficult conditions due to a weak real estate market. For the quarter the company reported that earnings fell 38% compared to 2007 with earnings per share dropping to just $.21 compared to $.35 a year ago. Net interest income was down 12% as a result of declining interest rate spreads. Since smaller banks rely more on deposit based funding than on the interbank and fed funds markets that larger banks favor. As a result their cost of funds does not decline as rapidly and margins can get squeezed. Other income fell 69% as real estate gains at commissions at Hyatt Real Estate felt the impact of a soft real estate market. Non accrual loans almost doubled in the quarter to $15.3 million. The bank increased its loan loss provision to $7.9 million to protect against further declines.

The news was not all bad for Severn, however. Both total deposits and total asset rose slightly in the quarter. Net cash grew by 77%, primarily due to rises in cash due form other banks. The loan portfolio shrank slightly in spite of the asset increase as management has been slow to deploy cash in the current real estate market. Severn also recently declared its regular quarterly dividend.

The company continues to have a strong balance sheet. The equity to assets ratios is 11.45, double that of the level I consider adequate for smaller banks. Leverage and capital ratios are all well above the level to be consider well capitalized. Severn's efficiency ratio is 46% as the bank continues to control expenses even in difficult times. The return in equity in what is considered a bad quarter for the bank is 9.33, well above many of the larger banks in the United States. Because of its sound operating performance and financial condition Severn Savings was recently named one of the best saving institutions in the nation by SNL Financial, a financial research firm that ranks savings banks and thrifts. In fact, Severn was number overall of the top 100 savings banks in the United States.

Severn conducts the bulk of its operations in Anne Arundel County, Maryland. The county is one on of the wealthiest in the country with average income and net worth levels that place them comfortably in the top 100. Anne Arundel County benefits not only from not only being on the shores of the scenic Chesapeake Bay, but its proximity to Washington DC. The county counts a large number of government employees as residents and is somewhat insulated from a jobs recession. It also contains the state capital in Annapolis. Annapolis is a tourist destination, rich with history, scenery and of course, seafood. Alan Hyatt is the current Chairman and CEO of the ban and his father, Lou is still active in the real estate operations. The Hyatt family has been in the real estate business in Annapolis and Anne Arundel County for decades. They have an in depth knowledge of property and developers in the county which gives them an advantage over out of town lenders.

Severn is cheap as well. The stock trades at about 8 times trailing earnings. There are no forecasts fo earnings since the bank has no analyst coverage, but based on the latest t quarter it should be below 10 times 2008 earnings well. Currently the stock trades at less than 80% of book value, a level not seen since the very early 1990s. On an absolute basis the shares have not traded at this price since 2003. Severn shares are down almost 60% from the 52 week highs.

The road ahead for Severn Savings undoubtedly contains more bumps. The economy shows no signs of recovering as the real estate market can be generously described as difficult. However, to long term investors, the chance to buy a conservative savings bank that is well run and well capitalized should pay handsome dividends over a 5 year market cycle.

WITH A $75 MILLION DOLLAR MARKET CAPITALIZATION,SEVERN IS A MICROCAP STOCK. TAKE GREAT CARE IN PLACING ORDERS.

Small bank stocks have continued to fall lately as pressure form difficult real estate markets continue to weigh heavily on their results. The index of community bank stocks, ABAQ, is once again flirting with new 52 week lows. Most of the banks have reported small earnings gains but have had to take large increases in loan loss provisions as well as rising net charge offs. Many of had to raise capital to protect their balance sheets and capital ratios.

As bad as business has been, it is starting to be reflected in the share price of many stocks. At least one group is starting to pay attention. Insiders at small banks are starting to buy stock at increasing levels as they bet on an eventual turnaround. In reviewing filings form just the last week I found more than 50 small to mid size banks where insiders have purchased stock in the open market place.

Sandy Spring Bancorp (SASR0 a bank based not far from me In Annapolis Maryland actually reported better profits for the quarter. In spite of loan loss provisions that almost tripled in the r Sandy Spring reported earnings of $.50 a share, a penny better than the year ago period. The stock is fairly cheap, trading at less than 1.5 times tangible book value. Sandy Springs is expected to earn over $2 a share, putting the stock at less than 10 times earnings. They also raised the dividend by a penny this quarter and the shares yield of almost 5%. Insiders have noticed with 4 different officers and directors buying stock in the open market in recent weeks.
Parke Bancorp (PKBK) is a small bank operating out of Sewell, New Jersey. The company announced earnings of $.31 a share, exactly the same as a year ago on a fully diluted basis. Deposits and assets both grew by double digits in the quarter, a period when many banks were struggling with decreasing asset values. Parke raised its cash and equivalents in the quarter to ensure that they had sufficient liquidity in the difficult operating environment. Although the company does not pay a cash dividend it recently distributed a 15% stock dividend to shareholders, the fifth time since 2002 they have done so. There have been 15 different insider purchases in the last six months, totaling over 21,000 shares. Currently insiders own almost 30% of the shares outstanding in the bank.

These are just two examples of small banks where insiders are confident enough of the future ot back their opinions with their checkbook. There are literally dozens of these small banks right now with equity to asset and tier one capital ratios that out them well into the well capitalized category. They are becoming extraordinarily cheap on the basis of price to book value and price to earnings. Although they are felling the effects of the weak real estate market, they do not have the complicated securities and leveraged loan problems of larger banks. As the economy recovers so will these banks. I except there to be substantial consolidation among small banks as well/larger banks will buy them to gain high quality assets and earning power going forward. At 1 times book value and 10 times earnings or less, the small banks are trading at about half the level where takeovers are usually priced in the small to mid size banking arena. Based on that, upside potential over a 3 to 5 year period would seem substantial.

Another week past, another bad week for bank stocks. Naturally, as always when it comes to bad news, the leader was Citigroup. The banking giant announced that they would have to take additional write downs in the next quarter. Although the losses will not be as large as the $10.5 billion last quarter, CFO Gary Crittenden did say they would be substantial. Continuing real estate and economic woes are having a negative impact on the banks real estate and credit card lending portfolios Mr Crittenden said that consumer credit remains challenging especially in the credit card portfolio where the losses are expected to be more than $5 billion. Results will also suffer form the inclusion of a $325 million loss on the sale of leasing company CitiCapital. This quarter Citi won't have a billion plus dollar gian form the sale of Visa shares to offset the losses either.

Ohio based Fifth Third bank announced last week that they would have to raise additional capital as a result of poor credit experience. In addition to cutting the dividend by better than 60%, Fifth Third announced that they were doing a billion dollar offering of preferred stock and hoped to raise another billion by years end with the sale on assets considered to be non core operations. Bank officials cited continued weakness in credit markets for the decisions. KeyCorp, another Ohio based bank cut its dividend by netter than 505 and said they would raise $1.65 billion to offset credit losses. In addition KeyCorp said that they would take a charge of over 41 billion as a result of an adverse tax ruling on a leveraged lease transaction.

Several research and investment firms noted that things are just not getting any better for the banks. Goldman Sachs released a report that said it was unlikely conditions improved in the sector until at least 2009. The Investment firm said that banks are going to have harder time raising money as the year goes on. So far this year, over $60 billion has been raised by banks via the sale of stock sand convertible securities. They also noted that as conditions worsened analysts will lower their estimates for banks earnings and this will push the price of banks stocks even lowered than they have already fallen. Merrill Lynch research analysts said that they did not expect the credit crisis to end until 2010 and that there will be more dividend cuts head for larger banks in the United Sates. Analyst Edward Najarian cut his estimates for banks earnings by an average of 22% he also expects loan charge offs and loan loss provisions to triple in 2008

It simply is not getting any better for the larger banks in the US. Calling a bottom in banks stocks is an exercise in futility. Several analysts and fund manager have done so in recent months only to see shares continue to fall. Faced with credit problems that now look to last at least a year longer than anticipated, dividend cuts, layoffs and falling earnings the industry is simply unlikely to offer attractive returns for awhile yet.

When the last bank stock bull throws in the towel and the shares trade 40% or more below where they are now, it might be time to buy the group. Until then, the risks far outweigh the rewards and I would avoid money center and regional banks for the foreseeable future.

The Fed has now lost all credibility. After the report cam out today announcing that they were leaving rates unchanged, the dollar fell strongly against the Euro, and Eurodollars rallied. Stocks might have risen but bonds fell. The rest of the world views the fed as a toothless creature . They cannot raise rates to halt inflation as the US economy remains very weak. Hey cannot lower rates because of very real and very strong inflationary pressures.

To make matter worse the report contains a sentence that says "Recent information indicates that overall economic activity continues to expand, partly reflecting some firming in household spending."Interesting. The previous report stated that economic conditions remained weak. When, exactly was this activity continuing to improve from? Not the last fed meeting. Today's headlines indicated that spending remains weak, and real estate was still falling in price. Warren Buffett indicated that consumer activity was getting worse in his opinion. Bill Gross of Pimco said the fed was jawboning and that there was more deleveraging and turmoil to come in the markets.

The report also expressed the feds belief that inflation pressure would abate later this year. Again, this is flies in the face of what is happening in the world. Wheat price rose on concerns of Midwest flooding. General Mills raised cereal prices as grain prices were hurting profit margins.

The fed is out of bullets. Hey lowered rates form over 5% to the current 2%. Nothing improved in the economy. Unemployment continues to rise and real estate continues to fall. None of this bodes well for banks for the next six months. There will continue to be an increase in credit card delinquencies and home equity loans. Charge offs and losses still lie ahead of us no matter what the fed does or does not do. The major banks are still much more of a sell than a buy.