From 1982 until the first half of 2007, global bank stocks led the secular long-term bull market in company profits. Long-term interest rates plunged from over 21% in 1981 to a low of just 3.5% in 2004. As a result, earnings at the majority of banks were literally stupendous, including huge dividend increases and massive shareholder buybacks.

But that party is over. And in all probability, bank stocks will remain poor investments over the next five years and beyond.

In the next few years, I see a host of formidable challenges facing the badly bruised financial services industry. This includes new government regulation, losing the traditional investment banking deal-flow and far less lucrative leveraged loan portfolios. All these factors are conspiring to make financial services stocks a dull investment proposition.

The Financial Sector - Flying High Until Last July

The Easy Money is History

Most banks have been operating as casinos for years…that is until last July. Suddenly the sub-prime crisis imploded credit markets.

Sub-prime’s collateral damage will revolutionize the way banks do business going forward. In all likelihood, some of the most profitable revenue streams on Wall Street will disappear, mostly those tied to CDOs or collateralized debt obligations and other illiquid and hard-to-price synthetic securities. Worse, government regulators are bound to reshape the way investment banks mark these illiquid securities. In some cases, I can see banks even forbidding to trade the more exotic and leveraged securities that risk trashing the financial system.

In a nutshell, the investment banking business model is about to change. For shareholders, this implies far less profits as traditional sources of revenues are streamlined or liquidated altogether in 2008 and beyond.

The Fed, Bear Stearns and Systemic Failure

In order to avert a probable run on U.S. and many international prime brokers in March, the Federal Reserve orchestrated a US$39 billion dollar bailout for Bear Stearns. This event marked what many pundits called the “end of the sub-prime crisis” because the Bernanke Fed unofficially guaranteed all major U.S. financial institutions would remain solvent.

The implications of this watershed event are enormous. The Bear Stearns saga shows with brutal clarity that modern financial markets are even more tightly interwoven than before. That leaves regulated institutions even more exposed to each other’s risks. The next U.S. administration will spearhead a global effort to legislate and superimpose a watchdog on the financial services industry as the threat of systemic collapse is addressed through policy initiatives. More rules or restrictions won’t be bullish for bank and investing banking revenues.

The bottom line for the banks and their shareholders is not inspiring.

Greater financial market regulation, especially as it pertains to credit risk, will reduce long-term earnings for most investment banks worldwide. Even with Wall Street’s uncanny ability to create new models to maximize profits, government regulation and a new set of restrictions will likely dilute the innovative financial product development.

Increasingly, the government will scrutinize dealers and market-makers to isolate where systemic risks threaten the global financial system. And I can see the government destructively harsh on Wall Street.

Buffett Correctly Predicts Shareholder Dilution

In an interview with the National Post in Toronto, Canada, earlier this year, Warren Buffett of Berkshire Hathaway urged his audience to avoid most bank stocks in the future. Buffett stated that although some banks might be fair long-term investments, other sectors of the market offer far superior returns.

Buffett correctly predicted a wave of rights offerings. In other words, banks diluted their own banking shares by issuing a rash of new, public shares to finance bulging losses. Five months after his speech in Toronto, Buffett’s prediction came true. Today, many U.S. and European banks have already announced new rights offerings this year to shore-up depleted capital ratios.

For the record, Buffett does own stakes in U.S. Bancorp (NYSE-USB) and Wells Fargo (NYSE-WFC). The former is probably the cleanest of all U.S. large-cap banks with no sub-prime exposure.

U.S. banks have already issued more than US$26 billion worth of preferred stock in 2008 to bolster their balance-sheets. Merrill Lynch this week announced a US$4 billion offering while Citigroup has issued billions in preferred securities since late 2007.

To date, global banks have lost over US$200 billion dollars with Switzerland’s Union Bank of Switzerland (NYSE-UBS) responsible for almost 20% of that total. The International Monetary Fund or IMF has pegged total losses tied to sub-prime and other credit losses to peak at roughly US$1 trillion. That suggests banks still have a stash of cash to write-down over the next several years.

Dead-Cat Bounce or Market Bottom?

From their lows in mid-March following the near-demise of Bear Stearns, U.S. bank stocks have gained 14%. Now investors are starting to bargain hunt amid the credit wreckage.

To be sure, some banks are probably worthy investments at these levels assuming write-downs have peaked and their respective dividends won’t be reduced or cut entirely. But for most of the financial sector, more pain lies ahead as other segments of the credit markets and real estate come undone.

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