Two Stocks to Bank On

“Too Big to Fail”

Breaking up Banks

Two Bank Stock Recommendations

I bank at one of the larger banking institutions in this country and have kept my account there for a number of years. My loyalty has been tested lately, though, on more than one occasion. I won’t go into all the details, except to say that my latest encounter was the doubling of the interest rate on my credit card for no apparent reason.

My problems, though, are minor compared to bank customers who have over-borrowed and cannot keep up with the required payments on their credit cards, loans, or mortgages. And therein lies the crux of the entire problem. For the past 25 years, consumers have been borrowing too much so they can enjoy the good life. State and local governments have been borrowing too much so they can provide more and more services. And now the U.S. Government is running huge deficits to help prop up a troubled banking system and a sinking economy.

Banks have received large sums of money to help them through their financial crisis. We all have been reading for the last several months about bank executives receiving large salaries and bonuses partially funded by the bailout money from you and me. It seems to me that bailout money ought to be restricted to help banks stay solvent and to provide much needed capital to make loans to you, me and businesses of all sizes.

I realized long ago that banks loan out tons of money when the economy is robust, but then become fearful and make loans hard to get when the economy is tanking. I believe that this phenomenon exacerbates the economic cycle. Loaning more money when we really, really need it during economic downturns would make more sense and would help the U.S. economy avoid the up and down cycles that are harmful to so many. What’s the solution? When times are good, banks and the rest of us should save for a rainy day.

While I’m on a roll … “Too big to fail” scares me. What is too big, and how is too big going to be determined? Will there be two banks that are too big, or will there be 100 banks that are too big? And what is going to be done about these banks besides pumping trillions of our tax dollars into “big” banks when they run into a problem or two? My solution? Go back to the good old days when banks did banking, brokerage firms offered brokerage services, mutual fund companies ran mutual funds, and insurance companies offered insurance.

Now we have financial institutions, like my bank, that offer all of the above and more. “Jack of all trades and master of none” comes to mind. Maybe we should break up our so-called financial institutions by restricting the services that they can offer. Oh no, did I say break up banks? My dad would roll over in his grave if he heard me offer that suggestion. But, as a customer, I would like to be dealing with an expert rather than a jack-of-all-trades. As an investor, I would prefer investing in a few stodgy old banks that pay hefty dividends on a regular basis, rather than financial institutions with questionable investments.

One final thought on how banks and financial institutions should be regulated in the future to prevent another crippling financial crisis. We have a lot of regulations already in place that would have helped keep us from getting into this current mess. If the Securities and Exchange Commission (SEC), for example, had diligently done its job, Bernie Madoff would not have gotten away with bilking hundreds of investors out of billions of dollars.

We even have banking guidelines that suggest that banks avoid investing in risky investments. Evidently, regulators found the word “risky” is rather vague and didn’t know how to apply such a rule. OK, let’s add an amendment or two to prohibit banks from specifically investing in derivatives, credit default swaps and all similar gambling strategies that might be created in the future. And it goes without saying that all regulatory authorities should be well staffed and well funded to ensure that all regulations are fully enforced. Enough said!

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Have all banks run amok? Not quite. I’ve gone out on a limb lately and recommended a couple of banks in the newsletter I edit, Cabot Benjamin Graham Value Letter.

Hudson City Bancorp (HCBK) owns and operates 127 savings bank branches in northern New Jersey and New York City. The bank specializes in writing jumbo mortgages in the more affluent counties of New York and New Jersey. High loan standards and the avoidance of the sub-prime market have led to Hudson City’s strong balance sheet and low mortgage defaults.

Hudson City is taking advantage of the current favorable interest rate environment and the lack of competition in writing jumbo mortgages. However, the company’s banking area includes residents who work in NYC’s hard-hit financial district. We expect earnings per share growth of 13.3% during the next 12-month period, which we believe will be sustained in future years. The dividend has been increased every quarter for the past six quarters and now provides an attractive 4.6% yield.Benjamin Graham Value Letter

HCBK is undervalued at 11.6 times forward EPS. The bank’s unique niche in the banking sector and its conservative lending practices make HCBK an attractive long-term holding. We expect HCBK shares to advance to our Minimum Sell Price within two to three years.

And …

Wells Fargo (WFC) provides banking, insurance, investment, mortgage, and consumer finance services throughout North America. Wells Fargo, founded in 1929, has been conservatively operated and therefore has experienced lower loan losses than most major banks.

The acquisition of Wachovia at the end of 2008 will more than double Wells Fargo’s loan portfolio to $850 billion. The purchase, however, added a greater percentage of delinquent loans and mortgages than the company’s recent experience. Wells Fargo has raised additional capital to meet new Federal requirements, but will need to raise additional capital soon.

We expect loan losses to diminish substantially before the end of 2009. We believe the banking industry faces challenges that will linger for several more years. Wells Fargo, though, is in good position to take market share from other banks, because Wells Fargo is generating strong cash flow and is improving its balance sheet. In addition, the acquisition of Wachovia at a fire-sale price presents a huge opportunity for the company to cut costs and streamline operations during the integration process.

WFC’s EPS were only $0.83 in 2008 but will increase to about $2.00 in 2009. At 11.5 times our $2.00 estimate, WFC shares are a bargain. The dividend, which was reduced recently, now yields 0.9%, but dividend payments could be increased as early as 2010. Warren Buffett is a major investor and Whitney Tilson, co-founder of the Value Investing Congress, recommends purchase.

Sincerely,

J. Royden Ward
For Cabot Wealth Advisory

Editor’s Note: You can read more about Hudson City Bancorp and Wells Fargo and get continuing coverage in Cabot Benjamin Graham Value Letter. There you’ll not only find buy and sell advice for the companies above, you’ll get dozens of other excellent value stock recommendations from J. Royden Ward each and every month. Roy applies the strategy of the father of value investing, Benjamin Graham, to find the market’s best-undervalued stocks. This year he’s already uncovered several stocks that were sold for double-digit profits! Don’t miss out on his next recommendations … click here now to get started today!

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