How Banks are assessed for financial soundness

Bank Stocks Are Hated, So Here Are Four I Like: John Dorfman
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Commentary by John Dorfman
March 2 (Bloomberg) -- Banks are unpopular these days, as President Barack Obama observed in his address to Congress last week. Even more despised are bank stocks.
In the 12 months through Friday, the diversified banks group within the Standard & Poor’s 500 Index fell 54 percent. Regional banks fell 49 percent.
For investors courageous enough to swim against the tide, now may be a good time to pick up bargains in the rubble of the banking industry. How can you tell which banks are on the safest footing?
The newly mandated federal stress tests for banks haven’t been run yet. Still, investors can get a pretty good idea of a bank’s viability based on two traditional financial-strength measures.
Start with the Tier 1 capital ratio, sometimes called the core capital ratio. Tier 1 capital is basically a bank’s book value, or corporate net worth. Banks are required to have Tier 1 capital equal to at least 4 percent of their assets. Assets for a bank usually consist mainly of the loans they have outstanding and can also include Treasury notes, bills and bonds held by a bank, and other investments.
While 4 percent is the required Tier 1 capital ratio, some banks have considerably more. Of the 119 publicly traded banks in the U.S. with a market value of $250 million or more, 73 have a Tier 1 capital ratio of 10 percent or better.
Grading on Risk
Next, turn to the risk-based capital ratio. In assessing this ratio, regulators grade the safety of assets held by a bank. The safest assets such as cash and Treasury bills are given a multiplier of zero. Those deemed to be moderately safe such as (ironically) mortgage loans have a multiplier of 0.5. Those considered riskier, such as commercial loans, carry a multiplier of 1.0.
If Gravel City Bank hypothetically had $30 million in Treasury bills, $40 million in mortgage loans, and $50 million in commercial loans, its risk-weighted assets would be $70 million (zero times $30 million, plus 0.5 times $40 million, plus 1.0 times $50 million).
A bank’s total capital is supposed to be at least 8 percent of the risk-weighted asset total. Total capital includes Tier 1 capital plus loan-loss reserves and certain types of debt.
Among the 119 publicly traded banks mentioned above, 22 have a risk-based capital ratio of 16 percent or better, as of their latest filings.
If one takes the intersection of the 73 banks that have better than a 10 percent Tier 1 capital ratio, and the 22 that score 16 percent or better on the risk-based capital ratio, the field narrows to 17.
Four Good Banks
Last week I looked at those 17 banks to select a handful that I think are good investment candidates now.
The ones I like are not household names, and many of them are small. They include the likes of Republic Bancorp Inc. of Louisville, Kentucky (with a market value of $392 million), SVB Financial Group of Santa Clara, California ($547 million) and Washington Federal Inc. of Seattle ($1 billion).
Republic Bancorp traded above $30 a share as recently as September. Lately the stock is about $19, trading at 12 times earnings and 1.4 times book value. No Wall Street analyst follows it; the only brokerage house that does is a Louisville regional firm, Hilliard Lyons, which rates it a “buy.” SVB Financial Group is the parent to Silicon Valley Bank. With its Silicon Valley location, it is heavily exposed to the ups and downs of the technology industry. In the fourth quarter it earned only 9 cents a share, down from 96 cents a year earlier.
Attractive Fundamentals
I like SVB nevertheless, partly because it trades at less than $17 a share, down from more than $50 as recently as October. That is only seven times earnings and 0.7 times book value.
Washington Federal is participating in the U.S. Troubled Asset Relief Program. It sold preferred stock and warrants to the Treasury Department in return for about $200 million. The stock, trading below $12, has been cut in half from a year ago. It trades at nine times earnings and 0.7 times book value.
For those who prefer a somewhat larger bank, I recommend BB&T Corp. of Winston-Salem, North Carolina (market value $10 billion). So far, BB&T has weathered the recession well. For example, earnings in the fourth quarter were 55 cents a share, down from 76 cents last year.
BB&T stock fetches about $16 a share, down from about $31 a year ago. It trades at 6 times earnings and 0.55 times book value. The dividend may need to be cut this year, but in the meantime the stock yields more than 11 percent in dividends.
The banking crisis seems as if it will go on forever, but it won’t. I suspect investors will make good money in selected bank stocks purchased now and held for two years or more.
Disclosure note: Neither I nor my clients currently own the banks discussed in this column.
(John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column.)