The 1 Reason Bank of America Investors Should Run (Not Walk)

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Banking, in theory, is simple. Collect deposit. Make loans. Earn a profit on the difference between deposit interest paid and loan interest received. Maybe even pay out a dividend or buy back some stock. 

What's the catch? It only works if the loans are actually paid back. And for Bank of America , there are still a lot of loans on the books that are not being paid as agreed.

How loan quality is measured
Every bank in the country gives each loan it makes a risk grade. Generally, the grades include some number of classifications for loans that are good. Warren Buffett's mortgage, for example, may be a risk grade A while your typical, good-quality mortgage loan to you or me may be a C. Both are good loans -- it's just that Buffett is a lot more creditworthy than I am.

When things get hairy and a loan begins to go sideways, there are a few risk grades that have been standardized by the FDIC. This is standardized for a variety of reasons, many of which are not germane to this article, but what matters to investors is that these problem loans are reported to the regulators and to the public.  

Usually, a change in risk grade is prompted by a loan falling behind on its payments. Banks may also change the risk grade of a loan based on other factors -- qualitative, quantitative, or otherwise as long as the decision is justifiable upon review during routine FDIC examinations.

I've included the FDIC's standardized definitions in the table below. It's important for bank investors to understand the progression from good loan to bad. After all, your investment in a bank stock is an investment in the loans that bank is making. You'll note how each definition focuses on the likelihood of a loss to the bank, as the primary, secondary, and third source of repayment fail in succession. 

 Risk GradeDefinitionTypical Number of Days Past Due
Special Mention A Special Mention asset has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution's credit position at some future date. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. 30-90 days
Substandard Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. 60+
Doubtful Loans classified Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable. 90-120+
Loss Loans classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future. 120+

Source: FDIC.

Bank of America's continued credit problems
To asses how a particular bank's problem loans stack up, analysts use a few ratios to level set the bank's portfolio. Most common is a simple ratio of problem loans relative to total loans. 

In Bank of America's case, the results are not pretty. The bank reported that as of June 30 of this year, 6.45% of total loans were non-current. This compares to an average of just 3.35% for the industry, defined here as commercial banks with total assets greater than $10 billion. For emphasis, that is more than 1.9 times higher than the industry average. 

If you include properties that Bank of America owns due to foreclosure, the picture doesn't get any better. Non-current loans plus these bank-owned properties represent 3.71% of total assets at Bank of America versus just 1.85% of total assets on average for the industry. 

Narrowing the peer group to other U.S. mega banks, Bank of America still under performs, although not nearly as badly. Wells Fargo reported 5.44% of loans were non-current, and JPMorgan Chase reported 4.56%.

Regional banks, generally speaking, have done a better job of addressing credit-quality problems. People's United Financial , a regional player in the Northeast, reported just 1.84% of loans being non-current. Regional banks that are large enough to have scale -- like People's United with more than $30 billion in assets -- but are not "too big to fail" and simple enough to maintain sound banking fundamentals are the banks driving the industry average. Its the mega banks like B of A that are being left behind.

In banking, simplicity and quality wins in the long run
As we await third-quarter results, stay focused on what really matters in banking: that loans are being paid back. For Bank of America, this is particularly critical, because until problem credit levels return to much lower levels, this bank is a hard company to own. 

In the meantime, look to regional banks that have healthy and current loans on the books. Over the long term, these are the loans and banks that will consistently perform, providing the stability needed for long-term success.

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The article The 1 Reason Bank of America Investors Should Run (Not Walk) originally appeared on

Fool contributor Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Bank of America and Wells Fargo. It owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.

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