U.S. banks rise from the ashes

Demand for investment banking also should improve as the global economy continues to grow.

Most U.S. banks are still working on increasing their capital reserves to be in line with the new, more stringent U.S. and global capital requirements. Among the four biggest U.S. banks, only conservatively managed San Francisco-based Wells Fargo & Co. has met those goals, although J.P. Morgan Chase & Co. of New York has a strong balance sheet. Charlotte, N.C.-based Bank of America (BofA) and Citigroup Inc. (Citi) of New York are still two to three years away from achieving full financial health – and are only for the stout of heart.

The higher capital requirements will reduce growth potential because they lower the amount that can be lent per dollar of capital. To compensate, some banks have taken advantage of the credit crisis to acquire weaker competitors: Wells Fargo became the fourth-largest bank by purchasing Charlotte-based Wachovia Corp.; J.P. Morgan bought most of the banking operations of bankrupt Washington Mutual Bank of Seattle and New York-based Bear Sterns & Co. Inc.; and BofA purchased subprime lender Countrywide Financial Corp. and Merrill Lynch & Co. Inc., both of New York.

Here’s a look at the four big banks in more detail:

– Bank of America has returned to its core business of U.S. banking, abandoning the vision it had five to six years ago to become a major international bank. It recently sold its international private-banking business, notes Charles Burbeck, head of global equities with Barclays PLC’s wealth and investment-management division in London.

Furthermore, some stock analysts think BofA may sell Merrill Lynch, as it isn’t a core business.

BofA’s core business includes Countrywide’s large subprime mortgage business, which Burbeck thinks may be a good place to be in the next four or five years as the housing market continues to improve. Subprime lending hasn’t disappeared; it’s just much more regulated now and, thus, less risky.

However, other analysts are concerned about the liabilities BofA has inherited from Countrywide. Matthew Nagle, portfolio manager with San Mateo, Calif.-based Franklin Templeton Resources Inc.’s equities group in Nassau, Bahamas, for example, says these liabilities are potentially very big and very hard to quantify.

A report from New York-based UBS Securities LLC, which rates BofA’s stock as “neutral,” agrees: “BofA is exposed to large and uncertain legal liabilities.”

Nevertheless, Burbeck doesn’t think BofA should be trading at half its book value. It isn’t likely to need additional capital from shareholders, he notes, and renowned investor Warren Buffett has bought shares in the bank. BofA’s shares are trading at about 0.5 times book value (vs 0.6 times for Citi, 0.85 times for J.P. Morgan and 1.3 times for Wells Fargo).

A report from J.P. Morgan Securities LLC in New York rates the stock as “overweight,” saying that there has been “some good progress” on mortgage-related issues, although “some issues remain to be resolved.” The report also points out that earnings should benefit from the “large cost-cutting program underway.”

And while John Hadwen, portfolio manager with Signature Global Investors, a division of Toronto-based CI Investments Inc. , prefers Citi and Wells Fargo, he notes that BofA has about 15% of its staff working on problem-solving, which “leaves a lot of room to bring down expenses.”

Net income for the nine months ended Sept. 30 was $3.5 billion on revenue of $66.7 billion, vs a loss of $545 million on revenue of $68.6 billion for the corresponding period a year earlier. (All figures are in U.S. dollars.)

BofA’s 10.8 billion outstanding shares closed at $9.12 each on Oct. 26. The J.P. Morgan report’s 12-month price target is $11.50, vs the UBS report’s $9.50.

– citigroup inc. suffered huge losses during the global credit crisis but has survived; in fact, Hadwen and Nagle both prefer Citi to BofA. Both analysts like BofA chairman Michael O’Neal, who oversaw an increase in book value per share to 2.5 times from two times when he still was chairman and CEO of Bank of Hawaii Corp. O’Neal, described as an “activist, hands-on” chairman, has already orchestrated a recent change in CEO to Michael Corbat from Vikram Pandit and will continue to direct strategy for Citi.

Although a UBS report rates the stock as only “neutral,” Corbat’s operations background is listed as a plus. Adds the report: “New plans for a more efficient Citi could emerge over the next few quarters, potentially creating a positive catalyst for the shares.”

Nagle, who’s a long-term investor, also likes Citi’s strength and opportunities in emerging economies, where its position is more dominant than in the U.S. The bank is the only one of the four under discussion that hasn’t made major acquisitions and, indeed, is shrinking its U.S. activities.

A J.P. Morgan report agrees that the Citi franchise is attractive in the long term, but rates it as “neutral” in the near term because the potential for return of capital to shareholders is limited and expansion will be curtailed by the current slowing in emerging markets.

Net income for the nine months ended Sept. 30 was $6.5 billion on revenue of $52 billion, vs net income of $10.2 billion on revenue of $61.2 billion for the corresponding period a year earlier.

Citi’s 2.9 billion outstanding shares closed at $36.60 each on Oct. 26. The UBS report’s 12-month price target is $39 and J.P. Morgan’s is $41.

– J.P. MORGAN CHASE & CO. has big commercial lending and investment banking operations. Thus, Burbeck considers the stock “a leveraged play on global growth” and doesn’t think it should be trading below book value. He describes the bank as “a quality company that had a lot of problems but has emerged with a much stronger balance sheet than its peers.” The bank also has a good track record for returning shareholder capital.

Nagle is even more enthusiastic, saying that even if the global economy just muddles through, J.P. Morgan “should still be able to generate pretty good growth.” He contrasts this potential with Citi’s, which will need a pickup in economic activity to deliver good growth in earnings.

A UBS report has a “buy” rating on J.P. Morgan’s stock, even though it will “likely take two years for its legacy servicing costs to approach zero.” However, the report says J.P. Morgan is “the strongest franchise”: the firm is expected to continue to acquire market share, and its ability to execute is an advantage in this difficult environment.

Net income for the nine months ended Sept. 30 was $15.6 billion on revenue of $73.4 billion, vs net income of $15.2 billion on revenue of $75.8 billion for the corresponding period a year earlier.

J.P. Morgan’s 3.8 billion outstanding shares closed at $41.16 each on Oct. 26. The UBS report’s 12-month price target is $46.

– Wells Fargo & Co. Despite operating primarily in California before the Wachovia purchase and, thus, having had to deal with one of the worst-performing real estate markets when the subprime mortgage crisis hit, Wells Fargo has “managed quite well,” Burbeck says. This is partly because of its conservatism; it didn’t offer 100% or self-certification mortgages.

Other pluses include the bank’s ability to cross-sell additional products when clients come into branches – something that is, Burbeck says, difficult to do. Wells Fargo also is also good at integrating acquisitions and rebranding. Burbeck notes that with the addition of Wachovia, Wells Fargo now is doing about one-third of the mortgage refinancing in the U.S.

The stock isn’t cheap, but Burbeck thinks earnings will surpass current market expectations.

A J.P. Morgan report has an “overweight” rating on the stock, noting the bank’s fee income growth opportunities from recently acquired loan portfolios, the expansion of its capital markets and wealth-management businesses, and its cost-reduction plan.

Net income for the nine months ended Sept. 30 was $14.1 billion on revenue of $64.1 billion, vs $12 billion on revenue of $60.3 billion a year earlier.

Wells Fargo’s 5.3 billion outstanding shares (Buffett owns 8% of the shares) closed at $33.97 each on Oct. 26. The J.P. Morgan report’s 12-month price target is $42.IE

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