Morningstar Advisor - June/July 2010 - 64

Sector Rap

The stability in the housing market could disappear if interest rates start to trend up or unemployment continues to rise. Foreclosures are actually set to increase as customers either flunk out of or fail to qualify for modification programs.

underprovisioning, while the regional banks continued to grow their allowance. 20% of J.P. Morgan’s pretax income was the result of the allowance recapture. On the flip side, the pretax income of BB&T BBT was dragged down 40% by its $100 million allowance build. This huge difference can be quickly explained by the aggressive nature in which the bigger banks confronted this crisis in the first place. The larger banks—with their creditcard portfolios and national attention—built up their allowance for loan losses far more than the typical regional bank and consequently have a larger gap between their current allowance and their typical long-term allowance level. In other words, the big banks punished their income statements to a greater degree on the downside and are now recognizing the upside earlier. While quarterto-quarter metrics may change, we expect with continued economic improvement by the end of 2010 most banks will see their charge-offs exceed their allowance for loan losses, giving their bottom-line numbers a rapid and much-needed boost.
Q: Are you worried about commercial real estate being the next shoe to drop? A: US Bancorp USB, BB&T, and Regions

these losses and should not require any of the top 10 banks to see additional capital.
Q: What about exposure to commercial mortgage-backed securities? A: CMBS are not a major concern for any bank,

with the possible exception of PNC PNC. Commercial real estate loans inside of CMBS tend to be to larger, more-established firms, because the smaller, more marginal loans gravitated toward smaller community banks that did not have the capability to securitize the loans. However, underwriting standards on CMBS loans weakened considerably between 2002 and 2007 before the market basically shut down.
Q: As with most sectors, there are few 5-star bank stocks at the moment, given how far the market has rebounded. Are there any banking stocks you’d recommend now? A: None that have 5-star Morningstar Ratings, but we like Bank of America, which has a 4-star rating. We recently raised our fair value estimate for Bank of America to $25 from $23. We expect consumer loan losses to peak in mid-2010 and commercial losses to peak in early 2011. We expect the company to continue to provision less than its charge-offs, reabsorbing some of its allowance for loan losses and temporarily boosting the bottom line. Consequently, we expect earnings to rebound sharply after the peak, even if the economy does not bounce back as quickly. Q: You’ll be launching credit ratings for banks in the second quarter of 2010. Can you describe your methodology?

A: The approach is similar to Morningstar’s general methodology for credit ratings in that it assesses credit quality in four independent ways. But given that banks are unique animals, each of those four metrics is custom-tailored. We calculate the Morningstar Business Risk and Distance to Default scores in a way similar to the way Morningstar calculates them for general companies, but there’s no Cash Flow Cushion measure. Instead, we test a bank’s capability to absorb losses by applying relatively high standard loss rates across various asset classes on a bank’s balance sheet. Q: Do you have an equivalent to the Solvency Score? A: Yes. The banking Solvency Score ranks banks quarterly on a relative percentile basis according to measures of capital, asset quality, earnings power, and liquidity. K
Haywood Kelly, CFA, is vice president of equity research at Morningstar.

Financial RF have the greatest exposure to commercial real estate problems. While the data give us some mixed signals, we believe that the commercial real estate cycle will be manageable for most of the large banks but will lead to the demise of some smaller players. We expect loan losses from commercial real estate to peak sometime in 2011. Higher capital levels will help absorb

64 Morningstar Advisor June/July 2010

Morningstar Advisor - June/July 2010

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2010