Comfort Zone Investing: Time to Buy Banks?

For the third quarter, banking industry profits took a mighty leap higher as revenues increased and loan loss reserves subsided. Net income for the group, about 7,700 banks and thrifts, was $14.5 billion. That's much better than the $2 billion made last year in the third period.

The percentage of unprofitable banks at the end of the quarter was the lowest level since June 2008, when the economy was near or at the worst. A year ago, almost 33% of all U.S. banks were bleeding red ink. Now, it's fewer than one in five: 18.9%. Almost two out of three banks reported higher profits for the quarter vs. one out of three banks last year in the third. But the quarter's good results aren't an improvement on the first and second quarters when profits were $17.7 billion and $21.4 billion respectively.

The big difference: one bank, Bank of America (BAC). It lost $10.4 billion all by itself with a charge due to financial regulations that made its credit card unit less profitable. Without that one charge, total profitability would have been $24.5 billion, continuing the upward improvement for the banking sector.

The main driver for this period's improvement: fewer loan loss reserves. That means banks aren't keeping as much in reserve for potential future loan losses. That's only possible if loan losses currently are subsiding. Also helping profits was stronger revenue and better loan quality. Banks reserved $34.9 billion for loan losses in the third quarter, 45% less than in the same period last year.

Interest income for the industry went up to $8.1 billion, an 8.1% improvement over last year. Investment portfolios earned $3.2 billion, well above the loss of $4.1 billion in the third period of 2009.

What's the take away for investors from all these numbers? Things are better at the banks. But they can't keep cutting loan loss reserves to make profits. In fact, Sheila Bair, chairman of the FDIC, said she was cautiously optimistic about banks but warned against cutting reserves too much. So profits have to come from better quality loans and more of them for most banks.

One drag on more loans is the new capital requirements. Capital requirements are the amount of capital a bank needs to support a loan. Usually it's about 8% but it depends on the type of loan, whether it's a home mortgage or a construction loan (are those made anymore?). The more "safe" a loan is perceived, the lower the reserve requirement.

The lesson regulators and banks learned from the latest recession is that "safe" had to be redefined and so did the capital amount needed to support a loan. Those rulings came on September 12 from The Basel Committee on Banking Supervision stating that lenders needed common equity (capital) equal to at least 4.5% of assets, weighted according to their risk. An additional capital buffer of 2.5% will be required to withstand future economic stress. Banks will have up to eight years to comply with the new rules, with certain ones coming within five years.

Some banks will have no problem with the new rules. In fact, if some don't meet the "buffer" rule, their only punishment will be to stop dividend payments, not closed or forced to raise new equity.

What can investors make of all this: the banks are stronger today than they were last year or the year before that. That they will get even stronger going forward as the new capital requirements take hold. That there will be some banks that won't make it because of past bad decisions or because they can't raise new equity to meet the new rules. Some of the banks that should be fine: Wells Fargo (WFC), State Street Corp. (STT), US Bancorp (USB) and JPMorgan Chase (JPM).

Some banks that may have difficulties: Bank of America (especially with the Countrywide acquisition coming back to haunt), M&T Bank (MTB), BB&T Financial (BBT), Comerica (CMA) and Citigroup (C).

It's a good time to look at banks. Warren Buffett is adding to his position of Wells Fargo in meaningful amounts. There are reasons to believe the worst is behind this sector and once it regains favor, the group could move higher very quickly.

Ted Allrich is the founder of The Online Investor, chairman of the board of Bank of Internet USA, as well as the author of the book Comfort Zone Investing: Build Wealth and Sleep Well at Night. In this weekly column, he offers advice to investors who are just getting started.