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Been pretty quiet on the board for a while now, so I thought I would post my thoughts on a sector I believe I am knowledgeable about - banks!

Was a banker for 8.5 years at a small bank, the kind that takes deposits and loans the money back out with the occasional bond purchase.

I have been holding an oversized portfolio allocation of banks stocks for a while with mediocre results. I have thought that bank stocks represented a undervalued sector due to investor concern about a repeat of the GFC which I thought was unlikely to reoccur. As with most of you I didn't see COVID coming.

Many banks have reported 2Q earnings this week with the following recurring themes on the reported earnings:

1) Earnings down due to provisions to the ALLL (Allowance for Loan & Lease Losses). According to longtime and respected bank analyst Mike Mayo NEVER have banks provisioned so much towards ALLL in relation to actual losses (in the current periods) than in Q1 and Q2 of this year.

A little tutorial on ALLL. It is a contra asset account, like provision for bad accounts receivable. The provision hits earnings, total asset value and equity value on the balance sheet. On the balance sheet is is Gross Loans minus ALLL = Net Loans. One thing that needs to be remembered is that for the most part it is the gross loan amount that generates interest income. The act of making large provisions to ALLL does not decrease interest income.

Decreases in interest income normally occurs when a loan hits 90 days past due, although in a few instances they may continue to accrue interest, but generally when a loan hits 90 days past due interest income is only recognized as it is collected and not accrued. Loan losses, writing off loan balances and uncollected accrued interest, can occur before a loan hits 90 days or past due or later depending upon the bank and the situation with the specific loan.

Again Mike Mayo the well respected bank analyst is "estimating" that over the next two years loan write offs will be triple that of normal times. If he is correct, given the recent ALLL provisions and bank share prices, there are bargains in the bank sector, but the shares of every bank are not necessarily a bargain.

2) Deposits are exploding upwards. For Bank of America, they reported deposits of $1,719 billion at the end of Q22020 versus Q12020 $1,583 billion and Q22019 of $1375 billion. While BACs deposit increases my be more than the average bank, the average banks is seeing strong deposit growth.

In my words, never have banks had so much money and at a time there is not much they can do with it. They can't really buy bonds because the Fed has bought so many that they pay almost nothing.

They have to be very careful in making new loans as the possible rough economic times that could be ahead could lead to significant loan losses. IT IS AN EXCELLENT TIME FOR STRONG BORROWERS TO COME IN AND BORROW MONEY, but there are several factors that makes a borrow strong and one is that they don't have much debt a situation they are unlikely to change to any great extent during a possible financial crisis.

Banks can't repurchase much stock for the following reasons: 1) It is out of favor at least in the press and public attitude and doing so could create problems for them. 2) Bank examiners would be all over them. 3) With all the growth in deposits they may need to retain equity capital for capitalization requirements although this somewhat depends on what they do with those deposits.

COVID and Banking

COVID effects just about every business in some way, but its effects on bank operations should not be that great. It has little effect on the deposit side of bank operations as that is 98-99% electronic and for the cash side of the business there are ATM machines and drive through windows. Loan generation is a little more problematic, but my old bank has gotten pretty good at generating loans without the borrower ever entering the actual building - instructions are emailed then a folder gets to the borrower with tags everyplace the borrower must sign and date.

The biggest COVID problem for banks is the economic problems it generates which often decreases outstanding loan balance and almost always increase loan losses.

VM - Long BAC, C, CIT, PACW, HWC, FITB and most recently BK
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