Zombie Banks Still in Business

Banks with weak loan portfolio quality were termed ‘zombie banks’ in an examination by Money Morning in 2009. Though projected to fail, those banks have emerged and now …

Banks with weak loan portfolio quality were termed ‘zombie banks’ in an examination by Money Morning in 2009. Though projected to fail, those banks have emerged and now pose an even greater threat to investors. Learn more about this in the full article from Money Morning.

In February 2009, I examined the top 12 U.S. banks and gave a generally bullish outlook for them, pointing out that at a fraction of net asset value, their shares were mostly good bargains.

Only a few banks had longer-term problems because of the poor qualities of their loan portfolios. I termed those "zombie banks," and warned that they might not emerge from public ownership.

Well thanks to U.S. Federal Reserve Chairman Ben Bernanke’s misguided monetary policies, I have been proved wrong. Even the zombies have emerged, and investors have made excellent returns on holding their stocks since 2009.

However, at this point, investors should beware: Those zombie banks are still among us and they pose an even greater threat to unknowing investors.

Let me explain.

The results of the recent second round of bank "stress tests" were secret, but they have allowed many banks to increase their dividends, amid great rhetorical flourish. But as investors we should not get too excited. That’s because bank managements have taken the opportunity, not to increase their dividends back to their robust 2008 levels, but to combine token dividend increases with useless share buybacks. Such actions benefit only management stock options and not common shareholders.

For example, Bank of New York Mellon Corp. (NYSE: BK) on March 22 said it would increase its dividend to 13 cents a share from 9 cents. It combined that announcement with the unveiling of a $1.3 billion share buyback program.

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That looks like good news – until you consider that before the end of 2008, BK was paying a quarterly dividend of 24 cents a share. In other words, shareholders have lost 44 cents per share ($0.96-$0.52) per annum – about $550 million. And those same shareholders now are also seeing another $750 million per annum put into share buybacks. And since BK is currently selling well above book value, the buyback will dilute book value.

Share buybacks are supposed to increase earnings per share over the longer term, as well as support current share prices, but they do no such thing if management has stock options. Instead, they allow management to increase the number of stock options it grants, up to the value of the buyback, knowing that they can issue the new shares without diluting earnings. That, in turn, spoils the bank’s earnings progress, damages the stock price, and reduces the options’ value.

As we saw in 2008-10, buybacks are almost always increased when times are good and share prices inflated, and cut back during bad times, when shares are low and could use the extra support. This problem is exacerbated when the regulators force banks to raise capital in bad times – as they did in 2009 – thus diluting shareholders further by increasing the share count at low prices.

Here’s a few other examples of what I’m talking about.

U.S. Bancorp (NYSE: USB) used to be one of the best stocks for income investors, paying quarterly dividends of 42.5 cents a share until the end of 2008. Now it’s announced a 150% increase in its quarterly dividend – to 12.5 cents a share – accompanied by a stock buyback of 50 million shares, worth $1.3 billion at the current price of $26. That’s not a great deal for shareholders, since USB had issued 139 million shares in May 2009, at $18 per share – a classic sell low, buy high robbing shareholder value.

Even BB&T Corp. (NYSE: BBT), in many respects a paragon among banks, raised its dividend to only 16 cents a share, up from 15 cents, compared with a quarterly dividend of 47 cents a share in 2008. It also issued 75 million shares at just $20 per share in 2009, compared with the current price of around $27.

And those are the good banks, I would point out.

Less well regarded banks such as SunTrust Banks Inc. (NYSE: STI) still have not repaid the government’s TARP (Troubled Asset Relief Program) bailout and are issuing yet another round of new shares in 2011 – further diluting their unlucky shareholders.

But for real chutzpah you have to go to Citigroup Inc. (NYSE: C), which having banged its share price down to as low as $1 a share and received a gigantic bailout from taxpayers, now announces that it too will resume its dividend – but only at 1 cent a share and only after a 1 for 10 reverse stock split that will (it hopes) raise its share price from the current $4.50 to a more respectable $45 or so.

These banks have had Ben Bernanke jamming monetary policy levers at full open for two and a half years – keeping interest rates at a record low range of 0% to 0.25% and adding over $2 trillion of quantitative easing. In these conditions, they have made money, but have shown precious little return for the shareholders and depositors who have contributed two or three times to their bailout (Once through TARP, again through additional share issues, and a third time through the artificially low returns they have received on their savings, far below the rate of inflation).

However, inflation is taking off – consumer price inflation was 3.8% in the last six months and producer prices and import prices are both rising at rates of more than 10%.

So the Fed at some point will have to raise interest rates. When that happens, the banks that have been living off the central bank’s gigantic subsides, borrowing at close to zero and investing at 4% to 5% in government guaranteed housing bonds, will find life to be a hell of a lot more difficult.

Suddenly, there will be no easy treasury games to play and they will have to go back to making money the hard way, finding solid customers to lend money to. At the same time, they will have large losses on their holdings of long-term Treasury and housing bonds, which they will have to "mark to market" as interest rates rise.

Nothing in their actions the last couple of years suggests that banks have managements that can cope with these forthcoming difficulties, or that they will do anything to provide decent returns to shareholders when these difficulties arise. Instead, they are much more likely to go whining back to the taxpayer to bail them out of their new losses.

Bottom Line: Avoid the banking sector.

This article was republished with permission from Money Morning.

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