Bank Stocks: The Smartest Plays Now

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But Oja and some other analysts caution investors that if they wait to see commercial loan default rates or losses peak before putting money into bank stocks, they will probably miss the boat on some good opportunities. In the wake of the savings and loan crisis in the late 1980s and early 1990s, commercial loan losses didn't peak until six months after the U.S. economy had begun to rebound, he says.

"Loan losses are a lagging indicator only if you can earn through it," says Miller at FBR. He believes banks won't be able to generate strong earnings for the next few years due to the excess provisions they'll have to set aside to cover losses.

Vacancy rates in office buildings and retail stores are climbing across the country, which puts property owners—the borrowers whose loans banks hold—at risk of not having enough income to service their monthly debt payments. Green at USC believes the commercial vacancy rate is now around 15%, vs. 10% normally. How high vacancies get will vary by city. Manhattan currently has a 13% rate, which has risen about one percentage point a month for the past three or four months. New York could be in for quite a big uptick depending on what happens with Wall Street layoffs, says Green.

Vacancies could eventually approach 20% in many of the markets in and around Los Angeles, while the rate in Washington, D.C., tends to stay fairly low due to consistent demand by lawyers and lobbyists.

Elusive Financing

"A lot of people who borrowed money in 2005 to 2007 are hoping something bails them out before they default on their debt," says Brad Case, vice-president for research and industry information at the National Association of Real Estate Investment Trusts. "The key is, can they do something about it? Can they find other sources of financing?"

With bank financing having dried up, the only other source of financing is equity capital. Even private equity capital is having a hard time now, which means the only form of capital available is public equity capital. But to raise that, you need to be a publicly traded REIT. Case expects a flurry of initial public offerings as private borrowers have no choice but to transform into public companies as their debt matures. Only the companies that can raise enough equity capital to pay off their loans will succeed in IPOs, however, he says. That will likely exclude borrowers who bought property using 80% and 90% loan-to-value ratios, he adds.

As in the early 1990s, when bank stocks gained 50% six months before the peak in nonperforming assets, "if you wait to feel good about buying bank stocks, you're probably going to miss a decent part of the rally," says Tom Kersting, an analyst at Edward Jones in St. Louis. Still, he recommends sticking with higher-quality names such as JPMorgan Chase (JPM) and Wells Fargo (WFC), which have been beaten down like weaker stocks but which may not see as much upside as other banks considered more risky.

The Long View

"The million-dollar question to me for the longer term is, what is the true earnings power of many of these companies? I don't think the stock price reflects that earnings potential at this point," he says.

Take Bank of America (BAC), now trading at 12 times the consensus earnings estimate for 2010 of $1.03 per share. However much damage the Merrill Lynch acquisition has done to the company's reputation and valuation multiple, Kersting doesn't believe the deal has hurt its long-term earnings potential. That's in contrast to a stock such as Citigroup (C), whose ability to grow earnings once market conditions improve continues to be uncertain, he adds.

Anthony Polini, a banking analyst at Raymond James (RJF), sees Bank of America as one of three banks poised to benefit specifically from the slow-growth economy likely to prevail in 2010. Bank of America, JPMorgan Chase, and Wells Fargo together hold one-third of total consumer bank deposits in the U.S., he says. Slow economic growth will keep banks' borrowing rates down, while capital constraints at many weaker banks will give Bank of America and the two other leaders pricing power to charge higher interest rates on new loans, he says. Bank of America earns 55% of its income from fees and only 45% from interest on loans, and that will also help. Polini expects the stock price to double in one year as the bank returns to a normal earnings level, and then triple in two years. Compare that with a 40% price appreciation per year that's usually cause for celebration.

Many banks expect to benefit as lending that had migrated away from the banking industry to finance companies in recent years comes back to the banks, says Oja at S&P. He estimates that banks held $7.5 trillion in outstanding loans as of Mar. 31, just 20% of total outstanding credit in the U.S. If banks can boost that market share closer to 25% or 30%, it would mean big inflows in income and higher earnings, he predicts. But it's hard to tell how much pent-up demand for commercial loans there is right now because of the state of the economy, he concedes.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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