The seven sins US banks still struggle with

In his first report on US banks at CLSA, Mike Mayo continues to be bearish on the sector, identifying seven deadly sins of banking that will remain a drag on bank performance.

Greedy loan growth, gluttony of real estate, lust for high-yields, sloth-like risk management, pride of low capital, envy of exotic fees and anger of regulators are the sins Mayo highlights in his report. These were the actions whereby banks increased risks to generate revenues.

Against this backdrop, it is not surprising that Mayo, who joined CLSA in March after two years at Deutsche Bank, is still underweight on the sector. He notes that the impact of the seven sins was to front-load earnings and back-end costs and says the impact of the bank's actions are being felt today but have only reached midstream with more pain to come.

CLSA predicts that loan losses will increase from 2% to 3.5% by the end of 2010, "given ongoing problems in mortgage and an acceleration in (losses on) cards, consumer credit, commercial real estate and industrial (loans)". Most of CLSA's estimates are below consensus forecasts, stresses the report. Even if mortgage losses are halfway to the peak, writes Mayo, card and consumer losses are only one-third of the way and industrial and commercial real estate problems are in the early stages. The CLSA report expects loan losses as a percentage of total loans to surpass the level during the Great Depression.

Government actions can alleviate the situation, says Mayo, but he reckons that the industry is in a Catch-22 situation. The government can either go easy on the banks and leave the toxic assets on their balance sheets, or come down hard, in which case banks will need to raise capital and dilute equity shareholders further.

"Atonement is possible," says the report, which emphasises its points with a slew of Biblical allusions. To atone, banks must "embrace lower levels of risk, leverage, growth, returns and maybe even size". The report also speculates that enhanced oversight of the sector could take it back to 1934-type regulation, which could potentially lead to a break-up of some large banks.

The three largest US money centre banks -- Citi, J.P. Morgan and Bank of America -- were 16 times larger at the end of 2008 than two decades earlier in 1988, notes CLSA, going on to comment that "at a minimum, regulators may curtail risk-taking and require higher capital levels at firms that, given their size, are potential threats to economic stability".

Mayo is not alone in some of his conclusions. Banks have themselves been cautioning stakeholders that the year will continue to be difficult. At J.P. Morgan's fourth quarter and full fiscal year earnings call in January, posted on seekingalpha.com, the US bank acknowledged that delinquencies are increasing and that credit card losses will increase as unemployment rises. Indeed, J.P. Morgan's chief executive officer, Jamie Dimon, in a letter to shareholders last week said: "We do not expect 2009 to be a good year for the credit card business."

CLSA initiated coverage on the US banking sector last week with an analysis of 11 large capitalisation banks, rating all of them either underperform or sell. Among the banks it has an underperform rating on are: Bank of America with a price target of $8, versus a current price of $9.55; Citi with a target price of $3, which is around the same levels it currently trades; J.P. Morgan with a target price of $24, versus $32.75 currently; and Wells Fargo with a target price of $14, versus $19.61 currently. (All share prices are closing prices on the New York Stock Exchange on Thursday, April 9, which was the last trading day before the Easter break.)

After CLSA issued the report on April 6, bank stocks traded weak for the next couple of days and some attributed this change in sentiment to Mayo's call. But an indication of better than expected first quarter 2009 results from Wells Fargo & Company last Thursday turned the mood bullish again. Wells Fargo expects to have earned a net income of approximately $3 billion in the first quarter, and said its acquisition of Wachovia last year has exceeded expectations. The numbers were significantly higher than consensus estimates and provided just the fillip investors seemed to need, sending the bank's shares 32% higher in one day's trading on Thursday. Wells Fargo is due to report its first quarter results on April 22.

But the results season is just beginning. Goldman Sachs is declaring earnings today, followed by J.P. Morgan, Citi, Bank of America and Morgan Stanley in that order over the next week. Investors will be hoping they follow the trend of Wells Fargo. And that they have already atoned for the sins Mayo has identified.