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The “smart” money is buying U.S. bank stocks. William Ackerman, who runs hedge fund Pershing Square Capital Management, recently bought 150 million shares of Citigroup (C). John Paulson, the manager of hedge fund Paulson & Co., added 11% to his already huge position in Bank of America (BAC) in the first quarter.

Do you want to follow the smart money?

I think the answer is in the short term, sure. The risks are still huge but pick the right bank and so are the rewards. You could be looking at a double within twelve months. Of course, pick the wrong bank, and you’re looking at dead money or worse. And the definition of “right” and “wrong” banks may take a little getting used to.

Let me take you through the smart money logic. By the end, I’ll handicap three bank stocks to add to your portfolio now or two more for the longer run.

Here’s how the smart money logic works.

Bank earnings have been getting killed during the financial crisis as banks have had to add to reserves against bad debt of all kinds—mortgages, commercial loans, and credit cards—and as banks have had to take losses on the falling value of securities they own in their own portfolios.

For example, Citigroup put aside provisions of $43 billion in 2009. Bank of America put aside a total $49 billion in 2009 as provision against loan losses.

At some point in 2010, the smart money figures, some of these banks won’t be putting aside quite so much money to cover future losses because the forecast of future losses will start to decline. A bank can still be showing losses from bad loans, but if the magnitude of those losses starts to decline, then the amount of those loan loss provisions will decline. And when the loan loss provisions start to decline it will mean a smaller deduction from revenue to cover those losses and higher earnings.

So if Bank of America, for example, sees its loan losses decline and has to put aside only half as much in 2010 to cover new losses as it put aside in 2009—a still huge $24.5 billion instead of a hard to imagine $49 billion—that’s $24.5 billion that goes straight to increased earnings. Bank of America’s net income in 2009 was just a tad under $15 billion so an addition of $24.5 billion would be huge earnings news. And that prospect is one reason that Wall Street analysts are projecting that Bank of America will earn $1.02 a share in 2010 after losing 22 cents a share in 2009.

This “smart money” logic tells you that you don’t want to buy just any bank stock.

  1. You want to buy shares of a bank that has been recording huge loan loss provisions.
  2. Where bad loans are in decline and forecast to decline even more in 2010.
  3. And where investors remain skeptical about the bank and its management so that the share price doesn’t already reflect all the future improvement in losses and loss provisions.

Oddly enough then, the “smart money” logic tells you to look for a mediocre bank rather than either a really terrible or really good bank.

So for example, you don’t want to go out and buy shares of Sun Trust Banks to execute this strategy—it’s just not a good enough bank. Net charge offs for bad loans are still climbing—up to 2.91% of total loans in the first quarter from 2.83% in the fourth quarter.

But you don’t want to load up on shares of U.S. Bancorp (USB) either—it’s just too good a bank. The bank didn’t escape all the damage of the financial crisis but it didn’t get as wildly overextended as many of its peers. Charge offs are projected to be just 2.35% of loans in 2010 and that’s even thought the loan book is growing. In addition the bank gets about 60% of its earnings from traditional consumer and wholesale banking and its two big fee-based businesses, payment processing and asset management account for about 40% of normalized revenue. Things never got bad enough at US Bancorp to give it the kind of leverage to huge loan provisions that the ”smart money” strategy requires.

There are two dangers in the “smart money” approach to watch out for.

The first danger is a double-dip banking recession either because the U.S. economy as a whole hits the skids (unlikely I think) or because a sector of the financial market hasn’t quite recovered and is so precariously balanced that even a slight slowdown in the general economy could produce a double-dip recession in that sector.

I think the biggest risk of that remains in the commercial real estate segment which lags even the slow recovery in the residential real estate sector. So a very good bank such as Wilmington Trust (WL) isn’t a good candidate for this “smart money” strategy right now because of its relatively heavy exposure to the commercial real estate sector.

The second is danger is that the stock’s price already discounts too much of the reduction in loan loss provisions and an improvement in the bank’s bottom line. In 2010 during the financial rally—yes, there was a significant rally in financials before the current sell off—regional banks outperformed the big money center banks and they’ve held up better in the sell off too. (Just chart Bank of America against Sun Trust to see what I mean.) That means that while you’re looking at a potential double in Bank of America, you’re looking at the very real possibility of a loss in shares of Sun Trust unless loan loss provisions drop really, really quickly in 2010.

(You’ll notice that I don’t list rising interest rates as a risk. I think the euro debt crisis has taken higher interest rates out of the Federal Reserve’s playbook for the rest of 2010. For more on the effect of the euro crisis on interest rates see my post )

So what are the best banks for this “smart money” strategy?

I’d say:

Bank of America, a huge but mediocre bank that took immense loan loss provisions in 2009 and that has already seen its charge offs fall. The decline in charge offs for bad loans in the fourth quarter was the first decline in charge offs in four years.

Citigroup, a huge and barely mediocre bank where loan loss provisions in 2009 were almost as high as at Bank of America and where credit losses also started to decline in the fourth quarter. They were a still huge $7.1 billion for the quarter but that was down by $800 million from the third quarter and marked the second consecutive quarterly drop.

JPMorgan Chase (JPM) isn’t as badly run a bank as, ideally, I’d like for this “smart money” strategy but because of problems in the company’s huge credit card portfolio the bank has run up big loan loss provisions and big charge offs that are now starting to decline with an improving economy. I don’t think this is a double but it should be good for a 60% of so gain.

Of course, you could throw out the “smart money” strategy completely and just buy the best banks you can find, such as US Bancorp and Wilmington Trust. I think you’d do just fine in the long run, but that’s no reason to turn up your nose at short-term profits. Short-tem profits still pay the rent.

Full disclosure: I own shares of US Bancorp and Wilmington Trust in my personal account.