Why I’m Still Not Buying Banks

With many of the bank P/E ratios reaching single digit “value” territory, it might seem like a good time to test the waters and begin investing in banks again. Even Warren Buffett said in a recent interview on CNBC that he’d be a buyer of certain banks in this environment.

But big risks lurk behind those seductive P/E ratios, risks that have me passing on the entire sector, still.  

SEC Settlements

Citigroup (C) just got taken behind the woodshed for a second time by the SEC, with a $285 million settlement for crafting and then selling debt to investors that it knew to be bad and was secretly betting against. From the charge:

The SEC alleges that Citigroup Global Markets structured and marketed a CDO called Class V Funding III and exercised significant influence over the selection of $500 million of the assets included in the CDO portfolio. Citigroup then took a proprietary short position against those mortgage-related assets from which it would profit if the assets declined in value. Citigroup did not disclose to investors its role in the asset selection process or that it took a short position against the assets it helped select.

One experienced CDO trader characterized the Class V III portfolio in an e-mail as “dogsh!t” and “possibly the best short EVER!” An experienced collateral manager commented that “the portfolio is horrible.”

The SEC has extracted almost $2 billion from financial institutions for their roles in the subprime crisis and all expectations are that more judgments like these are on the way.

Balance Sheet Surprises

Citigroup, along with Goldman Sachs (GS), Bank of America (BAC), JP Morgan (JPM) and Morgan Stanley (MS) benefited this earnings season from gains called “debt value adjustments.” The way the adjustment works is that since the values of these company’s credit default swap debts have been dropping (because insolvency potential is rising) the banks could theoretically buy the debt back for less than it was issued.

That drop in debt value is accounted for as a pre-tax gain even though it actually says more about potentially declining earning power. And it was a major driver in many bank earnings this quarter.

Unclear Path to Profitability

All the bad press over the BAC plan to begin charging a monthly fee for using debit cards should serve as a reminder that many of the profit drivers banks had counted on are no longer available and so they are forced to look for new ones.

The industry is bracing for some diminished earnings potential and we can see that in the lower employment figures, dropping bonus levels, and scaled back expansion plans.

So, while the big banks might look cheap on a trailing P/E basis, they have yet to work through serious issues from the financial crisis and they still have a rough patch ahead.

So for my 2012 investing, I’m looking at more optimistically valued businesses with stronger fundamentals, companies like  Costco (COST), McDonald’s (MCD) and Southwest Airlines (LUV).

Full Disclosure: Long COST, MCD, LUV.

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