When compiling a list of the banks most likely to perform poorly in the long-term future, it's all too easy to point to the banks doing the worst right now. But everyone already knows those banks are on the ropes, and that doesn't mean they're doomed to failure.
Continue Reading Below
That's why I'm not going to do that today. Instead, I'll be bold and call out three bank stocks that are doing pretty well but that may turn out to be duds over the long term.
1. Goldman Sachs
In my opinion, the best bank executive of the past half-century is Robert Wilmers, head of regional bank M&T Bank . You'd be hard-pressed to find a more impressive performance from a CEO (you can see the numbers for yourself). In 2011, as the world was still staggering from the financial crisis, Wilmers was featured laid out the problem with today's banks in a column in The New York Times. The columnist wrote:
Wilmers, it turns out, is that rarest of birds: a banker willing to tell harsh truths about banking. That, for instance, much of the money the big banks earn comes from trading profits "rather than the prudent extension of credit that furthers commerce." That derivatives had helped bring about the crisis and needed to be regulated. That bank executives were wildly overpaid. That the biggest banks -- the Too Big to Fail Banks -- were operating, as he put it, an "unsafe business model."
No other bank embodies this "unsafe business model" more than Goldman Sachs . The bank is hardly a bank at all in the traditional sense; it's the remnants of an investment bank partnership that nearly collapsed from the very derivative and trading businesses Wilmers cites.
What's worse for Goldman investors is that the vast majority of changes to bank regulation since 2009 have been targeted at these same trading, derivatives, and investment banking businesses. The bank is being forced to sell off highly profitable (and risky) investments in private equity and hedge funds. It's being forced to scale back its role in the commodities markets, and it's no longer allowed to trade with the bank's own capital, a practice known as proprietary trading.
Continue Reading Below
Put it all together and you have a framework for potential disaster. The bank is built on a model that has proved volatile and risky over time, and now the government is taking aggressive steps to essentially outlaw the core of the business. In 10 years, the "Vampire Squid" may be endangered.
2. Bank of America
You may be thinking, "Didn't he say he wouldn't pick the low-hanging fruit?" Yes, I did.
But consider that Bank of America has rebounded pretty strongly over the past few years. The Charlotte, N.C.-based megabank has outperformed the KBW Bank Index over the five past years by nearly 15%, and since 2012, the bank has not only outperfomed the KBW Index but also crushed the S&P 500.
That performance has been driven by strong fundamental improvements at the bank. CEO Brian Moynihan has successfully simplified the bank and implemented the cost-cutting initiative, Project New BAC, that will reduce expenses by $8 billion annually. He has largely put to rest the fallout of the subprime portfolio inherited from Countrywide. Fellow Fool John Maxfield wrote recently how the bank's shareholders now have some things to be optimistic about.
Despite these short-term successes, I still can't get on the Bank of America bandwagon, particularly from a long-term perspective. In life and in banking, history tends to repeat itself. In the bank's fourth-quarter conference call, I couldn't help noticing some subtle hints from Moynihan and company that Bank of America is already falling back into the same practices that have gotten the bank in trouble in credit cycles past.
The bottom line for Bank of America, in my opinion, is culture. If you want to find a bank that will underperform in the future, find one that has a history of taking on too much credit risk in the past. For over 20 years that has been the defining flaw in Bank of America's performance. I see no evidence that problem has been resolved.
3. New York Community Bancorp
If you were waiting for a truly bold prediction, here it is.
New York Community Bancorp is one of the strongest, most consistent banks available on the public markets. It has a dividend yield above 6%. It has an incredibly rock-solid record of making only the best loans. It's everything you could want in a bank stock, but I think that performance could reverse itself in the next 10 years.
Why? Because I can see the bank moving away from the strategy that has made it so successful. The bank specializes in making loans on apartment buildings in New York City, with a particular focus on rent-controlled buildings. It just so happens that those buildings are almost always 100% occupied because of the high demand for the controlled rent. High occupancy means the loans get repaid in good times, bad times, average times, and...well, you get the picture.
The problem facing New York Community Bancorp now, though, is growth. The bank currently sits just under the threshold of $50 billion in total assets. It has purposefully stalled its growth in recent quarters to delay passing that number, because it's at that asset size that a bevy of increased regulatory requirements take effect. That means higher expenses, higher scrutiny, and, all else being equal, lower returns. For a bank with a dividend payout ratio routinely above 85%, that's a big deal.
How, then, will the bank grow? Most likely through an acquisition that will leapfrog the bank over the $50 billion mark, giving the bank more assets and more income to offset the increased regulatory cost.
The downside, though, is that any potential acquisition(s) will move the bank away from its traditional rent-controlled apartment building focus into riskier and less familiar loans. Is it possible to make that transition and still put up strong numbers? Definitely. Is it a guarantee? Not even close.
I may be wrong about these predictions. There's no way to predict the future, and anyone who claims to should be regarded with suspicion. However, each of these banks characterizes qualities that I think can lead to long-term underperformance. And recognizing the risks, challenges, and headwinds facing a stock is just as important as understanding the upside.
The article The Worst 3 Bank Stocks for the Next 10 Years originally appeared on Fool.com.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Goldman Sachs and owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.