Big Banks are a Bargain -- But Should You Buy Now?

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$17 billion. That's how much stock market value has been wiped out at Bank of America ( BAC ) in the latest foreclosure mess. JP Morgan Chase ( JPM ) has seen its value shrink by several billion dollars, while Citigroup ( C ) and Wells Fargo ( WFC ) have seen their stocks hold their own through this latest debacle.

Wall Street analysts think that the scandal is not likely to have a big impact on these banks, and have started to suggest their shares are compelling buys. And they're right. But you'd be foolish to jump on just yet, with possibly daunting headlines looming in coming weeks.

Lemon laws not in effect
As a quick recap, it has become increasingly apparent that these banks botched the foreclosure process for many homeowners. To make amends, they may need to re-work many loans, which would reduce the value ofmortgage bonds by tens of billions of dollars. The major institutions that bought those bonds, such as the Federal Reserve, PIMCO and BlackRock Investments are crying foul, fearing that they will have to shoulder many of the losses. So they want the big banks, most notably Bank of America, to consider buying back massive amounts of loans and absorb the big hit that may be coming.

In the past few days, those beleagueredbond investors appear to be gaining the upper hand. To find out just what was in thosebond portfolios (and ultimately prove that the banks were negligent in handling mortgages), thebond investors need to come together to represent at least 25% of the entire purchase of thosemortgage bonds. A pair of law firms is leading the charge, and each looks set to cross that threshold soon. When that happens, look for lawsuits with 12 figure sums attached (that's $100 billion).

To be sure, banks won't be on the hook for all of the dud loans, only those where negligence and a lack of due diligence was involved. All of the banks, including Bank of America, will likely be able to pay out claims through cash flow rather than having to sell stock. Yet it will take an awfully long time to sort out the mess, and who knows how theeconomy will fare as the process drags on. If theeconomy slows from here while lawsuits are being settled, banks may need to come up with large sums of money right at a time when operating cash flow is evaporating.

A wide range of numbers
How much money are we talking about? A group ofmortgage bond investors led by PIMCO and BlackRock are asking Bank of America to buy back $16.5 billion in dud loans. That's only part of the estimated $47 billion in troubled loans that Bank of America may ultimately be on the hook for. Throw inmortgage bonds from other issuers, and the total industry exposure exceeds $100 billion. (The Federal Reserve bought back more than $1 trillion in loans, and is likely to seek some sort of massive payment -- known as "put-backs.")

An over-reaction?
Wall Street firms that follow these banks think investors may be over-estimating total industry exposure. They note that these lawsuits have to prove that eachmortgage was dubiously processed, and only those that have clear malfeasance will be subject to put-backs. So analysts think exposure will be in the billions, not tens of billions. They note that banks can easily overcome any payouts that will be necessary, and as they look past this morass, they see shares that are now undervalued in the context of eventual "normalized"earnings .

That may well be true, and when the full impact of this debacle is sorted out, and "headline risk" is no longer of concern, then investors will likely hop back on to these stocks. But in the near-term, shares could get hit again and again as lawsuits fly and the Federal Reserve looks at what actions to take. Moreover, estimates about total exposure are all over the place, and until investors can truly peg the banking industry's exposure, few investors will want to touch these stocks. For example, Credit Suisse pegs potential industry exposure at $65 billion. If they're right, shares of some stocks such as Bank of America and JP Morgan Chase could fall well further.

Action to Take --> There is one major bank that still holds appeal in this current environment: Wells Fargo, which has relatively small exposure to this crisis and may actually benefit from rivals' distress. [My colleague Ryan Fuhrman recently called Wells " The Best-Managed Bank in America "] If the mortgage underwriting business gets back on its feet in 2011 or 2012, Wells Fargo is much more likely to have the wherewithal to write fresh loans, as it won't be operating under a dark cloud. Shares, at a recent $26, look to have +50% upside when theeconomy starts to improve.


-- David Sterman

David Sterman started his career in equity research at Smith Barney, culminating in a position as Senior Analyst covering European banks. David has also served as Director of Research at Individual Investor and a Managing Editor at TheStreet.com. Read More...

P.S. -- There's an analyst with a track record you need to see. She has an 89% win rate -- remarkable for this market. And she just keeps picking winners. One of her recent picks shot up +18.2% in just 13 days. Go here for the details...

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Investing Ideas

Referenced Stocks: BAC , C , JPM , WFC

David Sterman

David Sterman

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