Just six months ago, at the bottom of the financial crisis during the darkest days of October and November 2008, it was unclear whether the American banking industry would survive.  Fannie Mae, Freddie Mac and AIG had already been effectively nationalized (more than 80% of stock owned by the Feds) and Citigroup, Bank of America, Morgan Stanley and others appeared to be on the doorstep of investor-owned demise. 

Now, in May 2009, the world seems a much better place for bankers and the rest of us that use bank money.   I for one, don't think banks will lead the market higher, but they need to at least regain their health and participate in the economy for growth to happen.  It seems they are on their way.  BAC, one of the sickest of the surviving banks, successfully sold over 1 billion shares after hours on Tuesday to close the gap on its capital needs according to the government "Stress Test". 

Dick Bove, who has been a lone voice for the survival of the banking industry, sees a very bright future for BAC, at least as compared to now.  He came public Monday with a statement that he expects BAC earnings to normalize around $4 per share, even after dilution, within the next 2-3 years.  Applying a 10-12 multiple to earnings, this implies a $40-48 future share price as compared to the $12 today. See his comments towards the end of the embedded news clip.

A great way to play the banks over the next few years is UYG, the leveraged ETF of the financial index.  UYG is today comprised mainly of the superior banks such as JP Morgan, Goldman Sachs and Wells Fargo, but BAC also has a place on this index.  Barrons posted an article on options trading strategies for BAC stock that might provide some ideas to capitalize on the return of the banks:

http://online.barrons.com/article/SB124265990717130781.html

Finally we are starting to hear some rational words about this banking crisis. Dick Bove is a somber and responsible bank analyst who is respected by many. Here are his thoughts on the financial industry:

(from Seeking Alpha website):

Punk Ziegel's bank analyst Dick Bove has issued another strikingly rational report that provides tasty food for thought. This one is entitled "Wait! Stop! Think!". In it he argues that the media is fomenting hysteria about the situation in the banking industry, which in reality remains quite sound.

Bove's been around long enough to have seen this before as an analyst during the 1990 bank debacle. While the media and government figures continued to predict dire outcomes and questioned the viability of the banking industry, bank stocks actually bottomed in late 1990 and appreciated smartly thereafter.

Is today's crisis worse than 1990? Bove points out several issues that were present then that aren't now:

Developing countries were nearly bankrupt
LBO's were failing

- Commodities were deflating

- Commercial real estate was in over-supply due to a change in the tax laws

- The credit derivatives market was in dire straits mainly due to the junk bond fiasco.

THOUSANDS of banks and thrifts failed.

The only direct parallel today is the credit market implosion. The other conditions don't exist. Only 76 of 8233 banks are on the FDIC watch list. Hence, it would be up to the credit market collapse to take the system down, which Bove says requires an implosion in the single-family mortgage market.

He estimates that if 50% of the sub-prime mortgages behind the credit derivatives market fail, and the collateral value of these loans is reduced to the land only (the houses are worth zero), that the total write down might be about $500B. Although painful, this would represent only 1% of the total debt outstanding in the US economy. It would easily be absorbed by the system.

There are other issues weighing on bank stocks:

A recent accounting change requires banks to value assets based on "comparables" rather than predicted cash flows. A variety of indexes were created to support this pricing requirement, yet the indexes lack liquidity and can be (and Bove believes are being) manipulated. The index which represents Commercial Mortgage Backed Securities is reflecting a default ratio of 6%, while actual defaults are at 0.27%. Yet banks must mark some of their assets to these indexes whether they reflect reality or not, deflating their balance sheets for no good reason.

Bank cash flows and true capital (as opposed to accounting entries which reflect a variety of non-cash adjustments) are actually in good shape. The current liquidity crisis is being caused by institutions unwilling to lend to one another, not by a true lack of funds. As opposed to a crisis where funds simply don't exist, a "fear of risk" based crisis will cure itself as interest rates adjust. Bove believes this is underway and may resolve itself soon.Bove picks apart yesterday's article in the Journal entitled "New Spasm Jolts Credit Markets" which made the following statement:"Rates banks charge each other remain elevated" - false because 3-month LIBOR has dropped (from 5.34% to 3% over the past 12 months) faster than Fed Funds signaling banks' willingness to lend to each other.

"The Price of insurance against bank debt default is soaring" - The point the journal makes here is that such insurance costs 20x what it did last summer. As Bove points out, that means it was one lousy forecaster of default last summer, so why should we believe it is a good indicator now? It is in fact a lagging, not a leading, indicator.

Interest rates on a variety of instruments are being "pushed up" - Then why is it that six months ago, 30 yr mortgages were 6.46% vs. 4.88% now, and AAA bonds were at 5.73% vs 5.48% today?"Banks are constrained for capital" - actually, common equity+reserves as a percentage of assets is just below an all time high. Bove believes the Journal (much like other media outlets, as I have previously commented) wants to sell bank panic just as it did in 1990. He notes that when he is quoted by reporters lately they highlight the negatives and ignore the positives. Bove concludes: "There is a financial panic underway fed by a defin able problem; a steady flow of misinformation; bad accounting rules; manipulated indices; a lack of understanding of bank cash flows and capital; a demand for higher risk-adjusted returns; and a lack of financial leadership."

He believes that bank stocks in general should be bought. None other than Warren Buffet agrees, as he bought shares of Wells Fargo (WFC) last quarter (I own WFC in some of my managed accounts). I know that when most everyone is leaning one way and sentiment becomes extreme in one direction, my gut instinctively tells me it's overdone and that the smart thing to do is be a contrarian. At the very least, be wary of taking media reports and market zeitgeist at face value. Conversely, I pay close attention to the few rational intelligent voices willing to go against the herd.