“Fifth Third Bancorp, I don’t know whether a fifth or a third is how much money you had left after their quarter a year ago but this year the loss is narrowed at Fifth Third in the fiscal fourth quarter…Let’s talk about KeyCorp. A good example of what’s going on, up about 4%. They did a little better than expected. The loss was not as bad as anticipated.” — CNBC’s Squawk on the Street 1/21/2010

Two of the larger regional powers in mid-west banking are surging today after reporting smaller than expected losses to close out fiscal 2009, but we see this as an opportunity for investors to cut ties with the still struggling banks.  Headquartered in Cincinnati, OH Fifth Third Bancorp (FITB) reported losses to shareholder totaling $160 million which compares very favorably to the $2.14 billion hit that the bank took a year ago.  KeyCorp (KEY), Fifth Third’s cross state rival based out of Cleveland, lost $258 million in the quarter which is less than half of the company’s loss taken a year ago of $524 million.  Fifth Third was actually able to achieve a profit for the full fiscal year thanks to a major earnings surprise from the second quarter, but consensus analysts’ expectations are calling for a loss in the year ahead at both banks.

Both banks reported seeing improving credit trends and charge offs were nowhere near as high as a year ago, but we think it is significant that both banks are increasing loan-loss reserves in anticipation of potential weakness ahead.  KeyCorp stashed away $756 million in the quarter which is a greater amount than was held in reserve in the quarter a year ago and the past sequential quarter.  They are now able to cover 4.31% of total loans outstanding, up from just 4% as of September 30th.  Fifth Third also increased provisions for future losses by $776 million, which was $68 million greater than the amount of loans that were charged off in the past quarter.  We can appreciate the renewed caution in regards to credit quality after the past few years, but it could also signal these banks are not yet sure that the asset value write-downs are over.

Surely, there were some positive signs as losses narrowed because there were fewer credit issues.  Also, net margin improved for both banks; FITB saw a 12 basis point hike and KEY’s net margin rose by 24 basis points.  Both banks have fortified their balance sheets with secondary offerings over the past year, which should help insulate them somewhat from continued economic weakness.  With that being said, we are not ready to advise buying these shares at current price levels, especially with KeyCorp trading 8% higher and Fifth Third 9% higher today as the market trades down quite a bit.

As of this week’s report we had an Overvalued rating on KEY and Fairly Valued on FITB.  Fifth Third was right on the edge of being downgraded by our methodology and today’s price appreciation may cross that threshold into Overvalued territory.  Both banks have been decimated by poor credit issues over the past year and have diluted earnings power through necessary capital raises.  These banks are still upping their reserves in case there is further deterioration to their credit portfolio, which makes us cautious as joblessness spreads and foreclosures persist.  To be sure, we think that there are less risky, more attractive stocks for value investors.

In an commentary piece on Bloomberg.com called Next Bubble to Burst Is Banks’ Big Loan Values, Johnathan Weil exposes some distressing nuggets of information that are buried in the footnotes of banks’ quarterly reports.  We encourage every investor to read the entire commentary, but a key portion is reprinted below.

“It’s amazing what a little sunshine can accomplish.

Check out the footnotes to Regions Financial Corp.’s latest quarterly report, and you’ll see a remarkable disclosure. There, in an easy-to-read chart, the company divulged that the loans on its books as of June 30 were worth $22.8 billion less than what its balance sheet said. The Birmingham, Alabama-based bank’s shareholder equity, by comparison, was just $18.7 billion.

So, if it weren’t for the inflated loan values, Regions’ equity would be less than zero. Meanwhile, the government continues to classify Regions as “well capitalized.”

While disclosures of this sort aren’t new, their frequency is. This summer’s round of interim financial reports marked the first time U.S. companies had to publish the fair market values of all their financial instruments on a quarterly basis. Before, such disclosures had been required only annually under the Financial Accounting Standards Board’s rules.” — Johnathan Weil, Bloomberg.com

Because of a recent change to Financial Accounting Standard’s Board rules, banks are now required to report on the fair-value accounting (also known as mark to market accounting) for the loans on their balance sheet each quarter.  Since, the FASB relaxed mark to market accounting rules, banks do not have to write-down loans that have lost value, unless they plan on selling them or they are nearing to maturity.  Mark to market accounting rules get a lot of blame for adversely impacting bank’s balance sheets as the market spiraled downward.  Interestingly, the market’s spring lows correspond almost perfectly with congressional hearings on MTM accounting.  The “relaxed” standards mean that although banks do have to specify the “fair-value” of their loans, they do not effect net income if the bank’s management intends to hold the loan to maturity.

Weil did the leg work and looked through a bunch of banks’ quarterly reports and found that a great number of them are in more trouble than it first appears.  Regions Financial (RF) is the most extreme case, but Bank of America (BAC) and Wells Fargo (WFC) as well as regional banks SunTrust (STI) and Keycorp (KEY) appear much less capitalized when looking at the value of their loans.  So, much of the recent rally has been built upon the foundation of a stronger financial sector.  Sure, banks are reporting profits again, but there are also a lot of nasty loans on the balance sheets of major banks.

Clearly, the relaxation of mark to market has served the purpose of giving banks a breather from book value destroying write-downs.  However, as Weil exposed, book value is really simply accounting fiction.  We are hopeful that in the balance of time a lot of these loans recover a substantial amount of value, but we do not want to invest based on hope.  Many of the credit issues that caused this mess are still yet to be worked out, and at Ockham we remain very wary of bank stocks.

Fifth Third Bancorp (FITB)—like  many other regional banks—has struggled through the current market environment and the stock is down more than 70% in the last year. The Ohio super regional bank has been hamstrung by bad real estate bets in the particularly depressed markets of Michigan and Florida.  The credit crunch is also making the real estate downturn that much more worrisome. Furthermore, Ohio banks are struggling mightily of late (FITB, KeyCorp, and National City to name a few) which does not bode well for the state’s economy going forward, as jobs continue to steadily leave the rust-belt. Today, FITB was downgraded by an analyst at BMO Capital and the stock is off more than 12%.

In a value methodology, such as ours, it is of great importance to be able to distinguish between a real potential value play and a “value trap”. The trouble for Fifth Third right now is that it was too exposed to the most inflated regions of the real estate bubble and those areas have plunged in value the fastest once the bubble burst. The national real estate market may well take a year or more to recover, but FITB’s holdings have likely already taken the bulk of their losses. The BMO analysts’ concern stemmed from the possibility of a dividend cut. While a dividend cut is distressing to shareholders, FITB’s dividend yield is a whopping 13% and there is no logical reason why a company should continue paying such a generous dividend while absorbing huge losses in its mortgage portfolio.

The stock continues to hit new 52-week (and multi-year) lows and the trading volume balloons on down trading days—such as today. There are a lot of reasons for pessimism about the stock, but a contrarian investor might identify this as an opportunity. Our valuation model is more attune to the company’s cash flow and revenues, as compared to historical norms. From this perspective there is reasonable cause for cautious optimism.

While revenue growth has slowed in the tough economy, FITB has historically traded at 3.1-4.3 times revenue. However, the stock is currently trading only at 1.08, which is about 35% of the low end of its historically normal range. The price-to-cash number is also at an extremely low level as the stock normally trades at cash flow multiples of 15.9-22.3. The price-to-cash flow measure currently stands at 6.67. So, by extension of this logic, if FITB could rebound to just the low end of the stocks historically normal price-to-sales and price-to-cash metrics, we would expect the stock to trade above $32. There is significant potential for a patient, long term investor who can ride out the stock until it rebounds because the current valuation is compelling.

Regional bank, National City Corporation ( NCC) appears to be in discussions to either sell all or a portion of itself and the most likely suitor is NCC’s cross-town (Cleveland) rival KeyCorp. ( KEY). Other potential buyers include larger banks Wells Fargo, JP Morgan/Chase or PNC. NCC has been in a tailspin of late, losing more than 70% in the last year. Much of this loss is because of NCC’s mortgage industry exposure. Mortgage losses were a key contributor to NCC’s very disappointing results for the fourth quarter–net income was only 6 cents per share compared to 36 cents the year before. NCC’s exposure to bad debt makes this acquisition far from certain but the bank does have substantial assets and could be an attractively-priced growth opportunity for KeyCorp.

In January, National City slashed its dividend almost in half to 21 cents from 41 in an effort to deal with its burgeoning credit troubles. In addition to cutting the dividend, NCC raised $1.6b in capital through the issuance of debt and preferred stock as a means to shore up the balance sheet after incurring subprime mortgage losses of $333 million in the 4^th quarter. Further contributing to its problem is the fact that NCC is primarily located in the struggling economic regions of Ohio and Michigan. Even so, there may be enough appeal for regional banks such as NCC to attract attention from either rival banks or private equity firms because of the stock’s greatly depressed valuation. National City is a relatively large bank and its $2.7b deposit base is a compelling asset. NCC also has a $1b stake in Visa, which is an attractive asset, but with a catch as NCC is not yet able to sell those shares in the secondary market.