Bank Stocks Are Bad, but Big Failures Unlikely

Regional banks will begin reporting earnings on Tuesday, and the market is primed for more bad news following a rash of recent dilutive moves by cash-hungry lenders.

Equity infusions of $7 billion apiece for Wachovia(WB) on Monday and Washington Mutual(WM) last week exemplify the challenges banks face with rising risk during the credit crunch.

But while dilutive actions like new stock issues and dividend cuts make banks an unattractive investment at the moment, an analysis by TheStreet.com Ratings suggests the industry's woes are not likely to lead to the worst fears of some industry observers -- the prospect of a major bank failure.

To identify institutions of concern among the largest 100, TheStreet.com Ratings focused on the 10 with the worst asset quality ratios and the 10 with the lowest risk-based capital ratios at the end of last year.

Capital Punishment

There is no question banks are going through a difficult time right now.

Wachovia and WaMu's efforts to raise capital includes stock sales, dividend cuts and private equity investments. Talks of deals also were in the air. JPMorgan Chase (JPM) was rumored to be among the suitors for WaMu before the bank announced its $7 billion capital infusion last week, and National City(NCC) is shopping around to find a buyer as quickly as possible.

But while these events are great news in terms of banks' survival prospects, they can be brutal for investors. WaMu's sale of $1.5 billion in common and $5.5 billion in convertible preferred shares to institutional investors diluted other investors' ownership in the company by roughly 50%.

Wachovia's announcement Monday that it would sell $7 billion in equity dilutes its common shareholders for the second time this year, along with cutting the dividend 41%. With a much larger shareholder base, how long might it take for that quarterly dividend to climb back to 64 cents?

Fifth Third Bancorp(FITB) is one of many holding companies reported to have made bids for the troubled National City, whose main subsidiary, National City Bank, has the distinction of being among the 10 worst banks for asset-quality and risk-based capital ratios, according to TheStreet.com Ratings' analysis.

We discussed National City in detail last week, noting why another rumored combination with KeyCorp(KEY) would be a bad deal for KeyCorp's shareholders.

The latest reports on potential suitors for National City center on Bank of Nova Scotia(BNS), Canada's third-largest bank holding company.

The Sky Isn't Falling

But while it may be a terrible time to hold stock in a holding company that may need to raise capital, there have been many predictions of much worse -- namely bank failures -- over the past year. And while several tiny institutions and the larger NetBank, have failed, there's little chance in the short term of the same fate awaiting the largest 100 banks and S&Ls.

The following are the 10 banks with the worst asset quality ratios as of Dec. 31:

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As we recently discussed in detail, Downey S&LA, held by Downey Financial(DSL), was required to include modified mortgages that were still performing, as part of its Dec. 31 nonperforming assets.

If we exclude the modified performing mortgages from Downey's year-end numbers, the institution's nonperforming assets ratio was 4.39%, its loan loss reserves covered 62.54% of nonperforming loans, and its ratio of nonperformers to core capital and reserves was 28.65%.

IndyMac Bank, the main subsidiary of IndyMac Bancorp(IMB), and Lehman Brothers Bank, held by Lehman Brothers Holdings(LEH), also had a high percentage of nonperforming loans as TheStreet.com Ratings recently noted.

Many of IndyMac's nonperforming loans were written down when transferred from held-for-sale to the institution's portfolio. Some of the writedowns were to cover anticipated credit losses, creating an "embedded reserve" providing more of a cushion on top of the loan loss reserves.