Published: November 14, 2009

The biggest screw-ups are failures of imagination.

The worst mistake is not foreseeing that things could have come to this. Executives and policymakers or anyone who wants to excel must always ask: "What's going to happen next? And how should I respond to it?"

This was on my mind the other day as I looked at a bunch of bank data.

A couple of quarters ago, I studied several of the major banks by looking and the "Assets & Liabilities" report from the Federal Deposit Insurance Corp. I'd noticed a glaring anomaly: One bank's loan-loss reserves had fallen dramatically.

Well, neato. That's an interesting piece of bank data, but what can I do with it?

I could have asked myself what was going to happen next.

Had I done that, I would have come to the (somewhat obvious) conclusion that the bank was going to have to add to its reserves.

What does that matter? Plenty.

Reserves are cash set aside to cover losses from bad loans. The only place to get more cash is from net earnings. What I should have anticipated, knowing as I did that reserves were lower than normal, was a significant charge against earnings to bolster reserves.

And that is exactly what happened.

Wall Street, which was not expecting the charge, pummeled the shares. Though no one saw the charge coming, I should have.

The trick I missed was using the information I'd found to predict what was next. I used my brain to crunch the numbers, but I hadn't engaged my imagination to conceive what they meant.

With that in mind, I took a fresh look at the FDIC's "Statistics on Banking" page and looked at the industry as a whole. It's possible to drill the numbers down to the individual bank level, but I was satisfied with the FDIC's breakdown by bank size.

To simplify this complex report, I threw out all but three numbers:

The first is the total amount of loans the banks have made to customers.

The second line is the amount of money banks have set aside to cover and bad loans.

The third line is the dollar amount of "nonperforming" loans. That's any loan that's no longer generating interest because customers aren't making their payments.
I calculated each size category's loan-loss coverage. This is the relationship between potential losses -- nonperforming loans -- and loss reserves. The figure is expresses as a percentage. If the result was 100%, then classified loans equaled potential losses.

If the number was higher than 100%, the bank had excess reserves. If the resulting percentage was less than 100%, on the other hand, that means the bank doesn't have enough cash on hand to cover impending loan losses.

As you can see in the chart, banks have increased their lending across the board, but their reserves are less than half their 2007 levels. Only 77.6% of nonperforming loans are covered by loss reserves. The data tells us that, as usual, large banks have the best loan loss protection, 80%. Small banks face a dire set of circumstances, as only about half their future losses are covered.

Does this mean that banks are in danger of failing?

In general, no. But this number clearly shows that bank health isn't what it once was, and recovery will be a long, hard slog. I say that not because of what we see here, on the industry's balance sheet, but because of what we can observe on its collective income statement.

The bottom line is that banks earned $4.5 billion last quarter.

But the chart shows us that banks currently have a $56 billion reserve deficit. That means that if banks charged off all of their $292 billion in non-performing loans tomorrow, they'd cover all the losses but $56 billion.

All of that would have to be charged against future earnings. At current levels of profitability, that means banks won't show an aggregate profit for 13 quarters, or 3.25 years.

Paying down the losses, writing off the bad loans, working with borrowers when possible and putting earnings into reserve will take the industry years. $250 billion in nonperforming loan losses will take banks 13.8 years to earn back. Even after the bailout and the stimulus package and a serious market rally, banks still have 5.7 times more bad loans on the books than they did two years ago.

I'm sorry to paint such a bleak picture. While some factors -- such as the worldwide recovery and increased profitability -- could brighten things up a little, the reality is that it's impossible and imprudent to predict when the banking industry could return to an era of substantial excess loss reserves.

No more bailouts are needed: Banks just have to be given time to earn their way out of trouble.

Some banks, believe it or not, are already on their way. Some look to be teetering on the edge of insolvency. Consider the FDIC data on the nation's four largest banks:

Of these four major banks, Wells Fargo (NYSE: WFC) is clearly on the soundest footing. It has more in reserves than it faces in potential losses, and it's making a tidy profit of $3.34 billion a quarter. Bank of America (NYSE: BAC) and J.P. Morgan (NYSE: JPM) will see a lot of their robust earnings going into reserve for at least the foreseeable future.

Citibank, on the other hand, is weak. It has ample reserves, but the bank continues to lend, which means it will have additional bad loans. The worst part is that the bank isn't turning a profit, so it has no way to replenish its reserves. This is an unsustainable business model.

Wells is, not surprisingly, richly valued, at about 36 times earnings and not too far from its 52-week high.

It turns out that finding an undervalued bank these days -- one with a clean balance sheet and strong earnings -- is a tall order. One bank that investors might consider is International Bancshares Corp. (Nasdaq: IBOC), which owns the International Bank of Commerce in Laredo, Texas.

This mid-sized bank has a modest $4.9 billon loan portfolio. Its $61.5 million loan-loss allowance covers 98.9% of its classified loans, and the bank could easily make up the difference from its tidy $66 million second-quarter earnings. Even better, the shares are trading at 8.3 times earnings, a nice -14.4% discount to its two-year average.

With a potential investment in mind, it's instructive to return to my original question: Using the information we have, what predictions can we reasonably make about the future?

And, just as importantly, how can one profit from it?

International Commerce isn't going to need to rat-hole its earnings to cover more bad loans. Even if all of its classified loans go bad -- and not all of them will -- it has plenty of cash to withstand these losses. At worst it is a quarter away from a strong cash reserve -- and no bad loans on its books.

How, then, to profit?

Easy. Add shares of this discounted community banker to your portfolio. If the FDIC data is any indication, Wall Street is bound to begin placing a greater premium on exceptionally sound banks like IBOC.

-- Andy Obermueller
Chief Investment Strategist
Government-Driven Investing