There is a lot of talk right now on Wall Street about exposure to sub-prime borrowers. These are individuals who have loans that they cannot really afford. Maybe they bought a home that was far to expensive using an adjustable rate mortgage, perhaps they are experiencing negative amortization where, despite their monthly payments, the principal balance of their loan actually increases each month.

Do the recent correction in bank stocks represent a buying opportunity or a bear trap?

Debits and Credits … Oh My!

Before we can begin, a short and simplified discussion of bank accounting is in order. I know, I know … hold your excitement.

A bank takes in deposits from customers who establish certificate of deposits, checking accounts, savings, accounts, and other products. It then lends these funds out to people applying for mortgages on their home, business loans, construction loans, and a whole lot of other projects. The difference between what the bank pays out to the depositors to keep the funds coming in (interest expense) and the interest it makes on the loans it underwrote for customers (interest income) is called net interest income. In the old days, a bank was almost entirely dependent upon interest income to generate profit for the owners and fund future expansion. Today, successful banks have a hybrid model that allow them to generate upwards of 50% of profits from fees such as merchant payments, credit card processing, trust divisions, mutual funds, insurance brokerage, annuities, overdraft charges, and almost anything else you can imagine.

When the loans are originated on the books, the cash is paid out to the borrower and an asset for the loan is established. The bank will then create a company-wide reserve on its entire portfolio of loans for expected losses. For example, they may say, “We think that 1% of all loans will default,” so they’ll open an accounting reserve that reduces the value of the loan on the balance sheet. Later, if these loans do, in fact, go bad, they have already created the buffer on the balance sheet to absorb the shock without really damaging reported earnings. In addition, they may view loans on an individual basis, creating a reserve when it appears that the borrower may have problems repaying the loan.

Bank Stock Crisis or Distraction?

As you can imagine, the adequacy of reserves is extremely important for maintaining a healthy bank. Federal regulators recently let the world know that they were very concerned that, at many banks, loan loss reserves had hit new lows, reaching levels that haven’t been seen since the real estate crisis of the late 1980’s and early 1990’s. If, for example, 4% of loans were to go bad instead of the 1% for which management had reserved, the results could be devastating to shareholders, wiping out an enormous portion of the book value and causing huge losses on the income statement.

This, combined with the expectation from some economists and analysts that the housing drop is not yet over, is causing serious concern (a lot of fee income can be generated from mortgage originations; less home sales equals less fee income.) Yet, low and behold, some big name investors including none other than Warren Buffett himself are picking up shares of a few select banks.

Are Bank Stocks a Buy? It’s All About Loan Quality

At the end of the day, it really comes down to the quality of the underlying loans in a bank’s portfolio. As one great investment giant said, it’s difficult to get a lot of eager young men and women who can instantly manufacture earnings with the waive of a pen to contain themselves when the economy is running strong and every loan looks like a good one. That said, it should come as no surprise that Berkshire Hathaway picked up shares of US Bank, in part I’d imagine because it actually experienced a decrease in the number of write-offs while the rest of the banking community is worried about excessive risk in the system. In addition, that particular bank didn’t appear to have any large-scale exposure to the sub-prime market. (Full Disclosure: I have owned U.S. Bancorp common stock for several years.)

When I acquired my position, I found it prudent to take the advice of Charlie Munger: “Invert, always invert.” Ask the question backward: If U.S. Bancorp, which is trading at a lower p/e ratio than the market as a whole, can raise earnings per share at 10% per annum, which it has stated is management’s explicit goal in the 10K and annual report, plus you receive a 4.60% cash dividend yield while holding the stock, what is the likelihood that, long-term, you are going to have very good absolute results regardless of the three to five year volatility assuming its loan loss reserves are conservatively estimated? Your probability of better than average returns is improved further if the stock is held in a tax-advantaged account such as a Roth IRA, Traditional IRA, etc. This question can be asked for Wells Fargo (which I also own) or any other bank; simply put in the assumptions, the cash dividend yield, and your estimate of the adequacy of the loss reserves. If you don’t know where to begin, get out a piece of paper and compare the loss reserves for comparable banks; anything way out of line should be cause for concern.