Can U.S. bank stocks continue their winning streak?

In February, I analyzed the top 12 U.S. banks to determine whether they really needed $1.5 trillion in taxpayer-provided bailout capital. I concluded that only a few of those banks seemed to be in any danger of collapse, and actually recommended several.

Policymakers and the market later came to agree with me: The Standard & Poor’s 500 Financial Index has more than doubled from its March low and several bank stocks have posted triple-digit returns.

An April review of the first-quarter financial results of the top 13 U.S. banks (I added Fifth Third Bancorp (NYSE: ), at a reader’s request, to make it a Baker’s Dozen) only reinforced my conclusions.

But now the second-quarter results are out and an examination of those financial statements makes it appear this optimism may have gone too far. And that could mean that bank stocks will pose more risk in the year’s second half than they did in the first six months of 2009.

Let’s take a closer look.

Stressed Out Over Stress Tests

The highly controversial government bank “stress tests” may be the best place to start. Since the results of the government stress tests (Money Morning conducted bank stress tests of its own) were published, a number of banks raised extra capital.

However, it’s now clear that the government’s stress tests may not have been stressful enough.

The government’s “more adverse” scenario postulated unemployment averaging 8.8% in 2009 and 10.3% in 2010. With unemployment already at 9.5% in June we have blown through the 2009 estimates. And with some economists actually projecting that unemployment could actually reach the 12% level next year, the government estimates for 2010 were clearly also too low.

Furthermore, neither scenario considered what might happen as a result of the enormous budget deficits, currently forecast at $1.8 trillion in 2009 and $1.3 trillion in 2010. If interest rates zoom up, bank profits will take an additional hit. On the other hand, the “more adverse” scenario assumed a 22% decline in house prices in 2009, followed by a gain of 7% next year. Recent good news in housing suggests those figures may indeed be a bit pessimistic. Overall, therefore, the fact that a bank passed the stress test is not a guarantee of future success.

Goldman Sachs Group Inc. (NYSE: ) and Morgan Stanley Inc. (NYSE: ) - onetime investment banks now operating as bank holding companies - fall into a separate category. Both institutions depend almost entirely on their trading prowess, which in the case of Goldman Sachs produced impressive results in the second quarter. However, I am old-fashioned enough to regard what they do as not really banking, and hence propose to ignore them in this piece.

The Indicators That Separate Winners From Losers

There is lots of information - about potential bailout needs and about possible investment bargains - that can be gleaned from the banks’ second-quarter figures and from the earlier government “stress test” results. In particular:

A number of banks did fine on the stress tests, but then went on to report thumping losses in the second quarter, suggesting the stress tests were wrong (my own ratings seem to have been more accurate!).

• Banks that have lost money at an operating level in each of the last three quarters are probably in terminal trouble, regardless of whether the “stress test” said they were okay.

• Banks that relied more on the Goldman-Sachs-type trading business had better quarters than the banks that relied upon more-traditional lending. I regard this as a danger sign, since that business is likely to be much less profitable going forward and some products (credit default swaps, for example) may land an institution in serious trouble. What’s more, it now appears that commodities trading is poised to come under political fire, particularly since it appears that regulators are looking to restrict risk.

• In most cases, such key financial-analysis ratios as stock price to book value (Price/Book ratio, or P/B ratio) have risen sharply in the last few weeks. If the bank is trading above book value, but is still making losses or tiny profits, it’s overvalued.

• Several banks did share issues at huge discounts to book value, badly diluting existing shareholders. As far as I’m concerned, any bank that has a management team that’s hostile to shareholders is a bank to avoid.

• None of the banks seem likely to pay reasonable dividends going forward, though BB&T Corp. (NYSE: ) is at least making an effort, with a dividend yield of around 2.7%. Over the long term, dividends are a key component of investment returns, so they should always be a consideration.

The Four Categories of U.S. Banks

Using these indicators, we can assess the viability of the leading U.S. banks. They can be divided, as before into four categories:

• Zombies: Institutions making persistent losses at an operating level. These subtract value from the economy and should be put out of their misery through controlled liquidation, with the healthy parts being salvaged. They are surviving only because of ill-advised government (taxpayer) largesse.
• Walking wounded: These may well need another bailout if troubles develop. Right now, however, despite the fact that profits are too low, these banks are currently operating adequately on their own. An intensification of economic downturn would push some of them into “zombie” status or bankruptcy.
• Risky but Proud: These banks have relatively high risks, because of acquisitions or their business mix, but appear to be overcoming the challenges they face. However, their profitability is poor and may remain so.
• Hidden gems: These banks have conquered 2008’s difficulties, taken care of their bad-debt problem, and still managed to make a substantial profit. Short of a repeat of 1929-33, they should continue to do so. However, many have seen their stocks soar, meaning their shares are often now overpriced - especially given the likelihood of a prolonged recession still to come.

A Baker’s Dozen for Bank Investors

That brings to a review of the 13-largest U.S. banks by assets as of Dec. 31 (ignoring Goldman Sachs, Morgan Stanley, and foreign-owned banks). They are listed here in reverse order of size (as measured by assets):

13. Fifth Third Bancorp (Nasdaq: FITB) - Zombie: With $120 billion in assets, this Cincinnati-based regional bank accepted a $3.4 billion Troubled Assets Relief Program (TARP) investment from the federal government. Fifth Third grew by buying other banks in the Midwest and Florida. At Monday’s closing price of $8.67 a share, the bank is trading at 67% of book value and twice its level of three months ago. It lost $1.2 billion in 2008 even after goodwill write-offs, and has lost another $26 million in the first quarter of 2009 - a bad result, since the 2008 disaster and the TARP investment should have allowed it to mark down its bad assets, taking “everything but the kitchen sink” into the 2008 loss. It posted an additional operating loss of $200 million in the second quarter, but showed a profit because of a $1.1 billion sale of its processing unit.