Many large publicly traded bank holding companies that have posted decent earnings during 2008 still don't look like particularly attractive stocks right now, once you look under the hood.

The federal government's bailout of Citigroup ( C - Get Report) on Monday lifted financial stocks across the board. The more gentle terms for investors, following punitive bailout efforts for Fannie Mae ( FNM, Freddie Mac ( FRE, convinced some that now is a good time to dip a big toe in the water and look for potential bargains among holding companies that have managed to hold things together.

Banks have taken a beating this year. The Federal Deposit Insurance Corp. on Tuesday announced another bad quarter for bank and thrift earnings, with a combined $1.7 billion in net income for the industry for the third quarter, compared to $5 billion in the second quarter, and $28.7 billion in the third quarter of 2007.

Not surprisingly, the main factor in the earnings decline was higher provisions for loan loss reserves, with securities losses running a close second.

The FDIC's "watch list" of troubled institutions grew to 171 from 117 the previous quarter. TheStreet.com recently discussed some of these companies, along with industry losses from preferred stock investments in Fannie Mae and Freddie Mac, when we looked at significantly undercapitalized banks.

But even the banks that have best weathered the storm so far sport unattractive price-to-earnings ratios and potentially worrisome exposure to risky securities.

Strongest earnings among large banks

Before listing the large publicly traded holding companies with the best year-to-date earnings performance through the third quarter, here are a few quick points about the data:
  • Only bank holding companies are included, since thrift holding companies are not required to file uniform financial statements with the Federal Reserve.
  • The data are based on preliminary holding company financial statements, as provided by Highline Financial, Inc., on Nov. 25. The data are subject to revision.
  • Capital ratios in the second table don't reflect any capital infusions from the Treasury's Troubled Assets Relief Program.

Here are the ten publicly traded bank holding companies with over $10 billion in total assets with the highest return on equity for the first three quarters of 2008:

Large Publicly Traded Bank Holding Companies
Year-to-Date, 9/30/08
Click here for larger image.
Source: Highline Financial, Inc.

Here are some summary asset quality and capital adequacy ratios for the group:

Asset Quality and Reserve Coverage
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Source: Highline Financial, Inc.

Not surprisingly, the list is dominated by holding companies that maintained strong loan quality or have a business model focused on fee income, like State Street ( STT - Get Report) (with loans comprising less than 1% of total assets) and Northern Trust ( NTRS - Get Report) (with loans up 30% of assets). Of course, these two have faced other problems during 2008, as we'll see below.

Finally, here's a look at how these companies' common shares have performed year-to-date, vs. their respective indices. The companies are grouped by index, sorted by declining year-to-data total return, assuming dividends are reinvested:

Market Performance Through 11/24/08 Close
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Source: Bloomberg

Trust Banks

The holding company with the best asset quality also had the worst year-to-date total return on common shares through Nov. 24, with State Street shares returning a negative 55%. While the company (virtually a non-lender) didn't face loan quality problems and had experienced no defaults on securities, there was no hiding from the overall financial crisis and the incredible decline of the market value of asset-backed securities.

State Street held up nicely through the first half of September, when fears about unrealized losses on securities held on the company's balance sheet and potential losses in money market funds managed by the company caused shares to plunge. Looking at State Street's regulatory filing with the Federal Reserve, these unrealized losses increased to $3.2 billion as of Sept. 30, from $2 billion in June. The company said in its third-quarter Securities and Exchange Commission filing that $2.09 billion in unrealized losses related to asset-backed securities, with $801 million collateralized by subprime mortgages and roughly $653 million collateralized by student loans."

A complete impairment writedown of the $3.2 billion would have reduced State Street's core capital by 27%, however State Street's Sept. 30 capital ratios were relatively high, with a leverage ratio of 8.36% and a risk-based capital ratio of 17.19%. While regulatory guidelines for these ratios apply only to the banks themselves and not the holding companies, they need to be 5% and 10% for a bank to be considered well capitalized. One more thing to consider is that these ratios don't reflect the $2 billion in capital the Treasury injected during the fourth quarter. Of course, by the price action, it's clear that despite State Street's good earnings performance, the overall feeling in the market is that the company will be forced to realize much more losses on asset-backed securities.

Like State Street, Northern Trust's common shares held relatively well through the first three quarters, even peaking at an intraday high of $88.92 on Sept. 15. Shares tanked in early October, when analysts' earnings estimates were lowered. The company then reported a third quarter loss of $129 million, mainly from $562 million in charges to prop up money market funds managed by the company, "support securities lending clients," and to "purchase certain illiquid auction rate securities that were purchased by a limited number of Northern Trust clients." Northern Trust still managed a not-too-shabby return on equity of 12.66% for the first three quarters of 2008, but its shares had a year-to-date total return of negative 42%.

Where are the bargains?

Four of the institutions posted positive total returns on common stock through Monday' market close -- FirstMerit ( FMER, Cullen/Frost Bankers ( CFR - Get Report), Commerce Bancshares ( CBSH and International Bancshares ( IBOC.

Looking at the third table, the multiples on the first three look quite high, especially for this market. While FirstMerit, Cullen/Frost and Commerce of Kansas City have fared well so far, having avoided high concentrations in residential and construction lending, it's hard to expect significant earnings growth in this environment, especially when considering that we're still early in the recession cycle.

The price-to-earnings and price-to-book multiples for International Bancshares of Laredo, Texas are more attractive. However, while the holding company's earnings held up through the third quarter, nonperforming residential and construction loans have been ticking upward over the past three quarters. Charge-off activity remained low through the third quarter, but can be expected to increase over the coming quarters, since the company reported $86.8 million in nonaccrual loans as of Sept. 30, up from $46.2 million the previous quarter. Net charge-offs for the first three quarters totaled just $5.5 million, while the company's provision for loan losses was $12.7 million. The company's strong overall asset quality has enabled it to maintain good earnings performance so far, but any significant increase in charge-offs will necessitate a large provision for loan losses, which will severely cut into earnings.

Be Careful

In conclusion, this is a very difficult environment to consider investing even in the holding companies whose earnings have held up the best. Many of the strongest holding companies stock prices look quite expensive, with price-to-book ratios approaching or exceeding 2, and P/E ratios of 14 or higher.

The ones that appear cheap have major exposure in their securities portfolios, like State Street, or potential for significant increases in net charge-offs. Even the ones with stellar reputations and attractive dividend yields, such as Wells Fargo ( WFC and US Bancorp ( USB look quite pricey, and Wells Fargo faces the prospect of cutting that 5.29% dividend, in the event that the integration of Wachovia ( WB leads to greater-than-expected losses.

Plus, as we just saw with Citigroup on Monday, some holding companies could be headed for a second helping from the Treasury trough, forcing them to suspend dividends on common shares.

Philip W. van Doorn joined TheStreet.com Ratings., Inc., in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.