Seven deadly sins
We are initiating coverage on US banks with an Underweight rating given the
ongoing consequences of increased risk-taking. A key implication is that loan
losses should rise to levels exceeding those of the Great Depression. While
problems have partly played out in mortgages, other areas are likely to
accelerate, reflecting a rolling recession by asset class. New government
action may not help as much as expected: loans have been marked down to
only 98 cents on the dollar, on average. We start with 11 US large-cap banks
and intend to expand this coverage.
Structurally, the “seven deadly sins of banking” reflect seven quantifiable
ways that banks took greater risk, such as through greed for loan growth,
gluttony for real estate, lust for high yields, sloth-like risk management, pride
in low capital, envy of exotic fees and anger of regulators. Each factor allowed
banks to have some combination of stronger loan and fee growth, lower
expenses, reduced credit costs, or greater leverage, all of which are being at
least partly reversed today.
The higher structural risk, while not new, is becoming more fully exposed
during the cyclical downturn. One result is that, while the economy should
stay far from a Depression, loan losses should exceed the peak level of the
Great Depression by late 2010. This stems both from a higher-risk mix of
loans (for example, there were no home-equity or credit-card loans in the
1930s, and a smaller percentage of construction loans) and what we feel is a
rolling recession by asset class from mortgages and construction to cards,
commercial real estate, corporate and other areas. Thus, while banks have
incurred many capital-market writedowns over the past couple of years, the
increase in loan losses is likely to continue, reflecting a partial transition from
the financial crisis to the economic one.
While upcoming earnings should be better than 4Q08 (less marks), assetquality
trends should remain at least as negative. We start our coverage with
the largest money center and regional banks (and intend to expand coverage
to include processing banks and brokers). Our initial ratings include SELLs on
BB&T, SunTrust, US Bancorp, Fifth Third and KeyCorp; and
Underperforms on Bank of America, Citigroup, JPMorgan Chase,
Comerica, PNC and Wells Fargo.
Our estimates are below consensus and we maintain a negative bias. Our
group view will change as we see problem assets reach a peak; this, however,
does not seem likely in the next 12 months.

Initiating sector coverage - Underweight
Bank earnings were front-loaded given the higher risk embedded in their
activities. The seven deadly sins of banking are ways that US banks increased
risk to generate revenues. These actions front-loaded earnings and backended
costs - the brunt is being felt today. These “sins” were not created in a
day but typically over 10-15 years. In almost each case, the extent of the
transgression, meaning excessive risk, could be described as somewhere
between the worst in a decade and the worst ever. Below is our list with a
summary of the issue:
􀂉 Greed for loan growth - Once-in-a-generation excess
􀂉 Gluttony for real estate - Historic asset concentration
􀂉 Lust for high yields - Loan losses exceed Depression (est.)
􀂉 Sloth-like risk management - Highest-ever consumer debt
􀂉 Pride in low capital - Lowest level in 25 years
􀂉 Envy of exotic fees - Exotic turns toxic with $400 billion of charges
􀂉 Anger of regulators - Public backlash
Consequences are only midstream
The impact of excessive risk, while already seen, still has more to go in our
opinion, especially given a rolling recession by asset class. While mortgage
losses may be half way to the peak, card and consumer losses may only be
about one-third of the way and industrial and commercial real estate
problems (except construction) seem in the early stages. Loan losses, as a
percentage of loans, will likely pass the level of the Great Depression. Other
pressures to income should include lower revenues (less loans and fees),
higher expenses (more oversight costs), and dilution of shares outstanding
(insufficient capital), likely leading to ongoing earnings shortfalls through
2010. Per the balance sheet, banks will likely need a permanently higher
capital and reserve levels, implying lower ROEs and less reserve releases
when the cycle is over.
Ongoing downward earnings bias
Even with below-consensus estimates, we still have a negative bias given
seven separate areas of excessive risk. The housing bubble is only one of the
seven factors, reflecting our view that issues reflect not only a mortgage
bubble but a larger credit bubble. Compounding the problem is that many of
these risks have never been tested at their current size in a downturn.
Moreover, the fallout from these seven areas of excessive risk - each one
significant in its own right - gets compounded by having them impact
collectively. This is not to say that some banks cannot benefit while others
suffer, though few may be able to escape the industry headwinds.
Slower natural rate of growth only partly to blame
A key macro issue is that the natural rate of bank revenue growth slowed
given a more mature industry and a lower rate of nominal GDP. A key micro
issue is that bankers failed to recognize this tougher reality. While efficiency
gains seem to have created economic value for the industry, much of the
industry’s growth over the past decade seems to have evolved from a high
level of risk versus economic value creation. Accomplices include
managements, directors, shareholders, analysts, regulators, and financial
companies other than banks such as government-sponsored entities,
mortgage lenders, mortgage brokers, insurers, and other nonbanks that
helped to drag down good banks along with the bad.