Morningstar Advisor - Summer 2008 - 70

Sector Rap Stocks to Buy Once a Decade By Justin Fuller The current credit crisis has provided a once-in-a-decade opportunity to buy the large money-center banks. Now that many of the large money-center banks have retrenched and raised capital to support their balance sheets, Morningstar analyst Ryan Lentell is cautiously optimistic about their long-term prospects. I recently sat down with Ryan and his colleague Jaime Peters to review what’s happened and where they think we’ll go from here. Justin Fuller: One can’t help but hear about the massive write-downs at many of the large money-center and investment banks over the past several months. Can you give me an overview of what has happened? Ryan Lentell: The root of the problem was that RL: I think the majority of the write-downs tied directly to subprime mortgage-related securities are likely behind the large U.S. banks. These securities have all been significantly marked down, and since mid-March the market for these securities has shown signs of improvement. Moreover, a significant amount of pessimism around the continued decline in housing prices is already priced into these securities. That said, things could always get worse, and there is a tremendous amount of uncertainty today about when we will see a bottom in real estate. Additionally, I think many of the commercial and retail banks (like Citigroup C, JP Morgan Chase JPM, Bank of America BAC) will still have to continue adding significant amounts to reserves for losses relating to loans held to maturity over the next 12–18 months. Unlike investment securities, loans held to maturity are not marked directly to market prices. Instead, banks create provisions on their balance sheets to account for expected future losses. Currently, we believe that credit performance will continue to weaken in the near term; therefore, we believe provisioning levels will remain high. JF: Do you think the majority of the capital the big banks appears adequate. However, each bank’s financial strength is different. For example, JP Morgan is operating from a position of strength today, while Bank of America’s position is somewhat weaker. For specifics, I would point investors to our individual company reports. Additionally, I would say that if it appears the economy starts to soften even more than it is today, we might see some banks look for capital prematurely. For the most part, the banks would prefer to be overcapitalized than undercapitalized, given the high uncertainty about the future direction of the markets. JF: One criticism of these banks as potential many of the large banks were holding large positions in mortgages, mortgage-related securities, and leveraged buyout loans on their balance sheets. As the issues surrounding the subprime mortgage market collapse started to weigh on housing and the housing bubble eventually burst, these securities lost tremendous value. As a result, banks had to take large write-downs. Because banks are highly leveraged and operate with a small amount of equity in relation to the total amount of assets on their balance sheets, many of those that reported large quarterly losses were forced to seek outside capital to plug the resulting hole in their balance sheets. JF: How much worse do you think it can get? investments is that their core earnings power will be permanently impaired. What is your take on that? RL: This criticism comes up a lot today, specifi- raises are over for these banks? RL: This is the big question today. As we look at it, the capital positions at the majority of cally with the investment banks. Going forward, it is likely that there will be somewhat more regulation of investment banks following the collapse of Bear Stearns and the Federal Reserve’s extension of credit directly to the primary dealers. Today, the form of any increased regulation is just conjecture. It is likely that the investment banks will operate with somewhat lower leverage, and in isolation, lower leverage would reduce earnings. However, as leverage is coming down, risk premiums are increasing, and I think that this will mitigate much of the effect of the reduced leverage in the long 70 Morningstar Advisor Summer 2008

Morningstar Advisor - Summer 2008

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