It’s almost impossible to value big financial institutions like Citigroup (C), Bank of America (BAC), or Goldman Sachs (GS) — they’re a lot like hot dogs — you don’t really know what’s inside of them; for the most part, they’re leveraged hedge funds.

They may appear to be cheap on a price-to-book basis, but the book is an illusive concept when it comes to financial stocks, especially when leverage, a deteriorating economy, and accounting assumptions may transform the book into a pamphlet in a New York second.

There are very few financial companies that one can actually analyze and thus value — American Express (AXP) is one of them, and I believe it’s a great proxy for other financial stocks. American Express’s financials are transparent, thus you can make some fairly reasonable assumptions of its normalized credit losses (net write-offs), borrowing costs, fixed costs, etc… and come up with a ballpark earnings power.

In 2007, American Express earned $3.26, however, at the time, its net write-offs of its credit-card portfolio were hovering at an all-time low of 3.3%.

American Express was benefiting from the temporary impact of a new bankruptcy law passed in 2005 (people rushed to file for bankruptcy before the stricter law went into effect, which lead to lower bankruptcy filings in 2006 and 2007), in addition to easy access of credit through home equity loans, low unemployment, and expanding economy.

The 3.3% net write-offs are not coming back anytime soon, so $3.26 of earnings (which implies a price-to-earnings ratio of 10 at today’s price) is a number we can dream and fantasize about, but won’t see for a long, long time.

Fast-forward to today: American Express’s losses almost tripled, approaching 10% (though this number is a bit exaggerated by American Express proactively cutting available credit to its customers). Wall Street expects the company to earn $1 per share in 2009. However, similar to $3.26 earnings per share, this number is not really meaningful either – bad times, as good times, will not persist forever.

To figure out American Express’s normalized earnings power, you need to make an assumption of its normalized net write-offs, among other assumptions (borrowing costs, new level of fixed costs, size of the portfolio, growth of discount fees, etc…) with which I’ll not bore you here.

Though American Express’ credit card portfolio losses may go even higher in the short run, in the long run they’ll decline toward their historical average of 4.5% to 5.5%. In this case, the company’s earnings will be somewhere between $1.9 to $2.3, thus creating a price-to-earnings ratio of 14 to 17 times, turning American Express into a fairly valued stock. (If the “new” norm for net write-off will settle at a higher number, my earnings estimates are off. FYI: 0.5% of higher write-offs reduces earnings power by about 20 cents a share).

Today’s American Express price reflects a return to a normal environment – to which we have not returned yet – and the road to that goal may be longer than we expect and bumpier than we’d like (unemployment – the most important factor driving credit card defaults – is still rising).

But even if American Express has earned its normalized earnings today, the stock would be fairly valued at best. What’s the upside? The same is true for many other financial stocks.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

But here is a very significant positive – it will be able to borrow from the Fed, paying a puny 1-1.5% to fund its credit card portfolio. AmEx becoming a BHC removed a liquidity risk a risk that AmEx will not be able to fund float and provide credit in its credit portfolio. Fed funds and discount rates will not stay at these levels forever but an increase in the rate will coincide with an improved economy and stabilized credit markets and thus AmEx will not need the Fed anymore.

I did a fairly in-depth analysis of AmEx in March 2008, though many things have changed since the thesis has not changed that much.

Why would somebody ever give a loan or buy airline bonds of any country?  I can understand buying distressed bonds or maybe a stock as a trade. Not my kind of thing, but I can respect that. But a buyer (an investor) of fully priced (at par or close) airline bonds usually intends to hold them to their maturity, or for a long time. It is well documented that the airline industry as a whole has lost money over its cumulative existence. Thus, uneconomical, low fares that consumers have been enjoying over the years were subsidized by bond and equity investors. This is great for consumers, not so good for providers of capital. I almost want to say “Fly, don’t buy.”

One could argue, “but wait, Southwest (LUV) and Virgin have done well.” And maybe this is where the answer is, at least in part. We look at these very rare success stories and think that this time is different and the industry can reinvent itself and start making money. It’s rarely different.

Or maybe the answer lies in our forgetfulness? We forget that the deck (the industry structure) is stacked against us, that for every Southwest and Virgin there are dozen airlines that went through several bankruptcies, at least once. We look at glamorous, sophisticated, electronics-laden airplanes and forget that this is a very cyclical, capital intensive (planes cost hundreds of millions of dollars), low return on capital, highly unionized, debt burdened industry that is exposed to the gyrations of commodity prices. And to top it all, the industry has marginal pricing power and surprisingly low barriers to entry (i.e. new entrants compete with major airlines on one route at a time, it is similar to a death by one thousand cuts. Virgin Air was started with just couple million dollars and leased planes).

Russian airlines are even worse as they are forced to compete with a semi-government and thus not-for-economic-profit entity – Aeroflot. Also, the Russian government is predictably unpredictable. One day it may decide that it wants to control the airline industry and suddenly we’ll discover that airlines were ruining the environment, not paying taxes, scratching runways or whatever else it’ll need to say to justify ripping off equity and bond holders. It did this with many BP PLC (BP) and Royal Dutch Shell (RDS-A) holders a few months ago, so why would this time would be any different?

I suggest the rating agencies rethink their rating scale to accomodate for airline bonds: (A) – High Quality, (B) – Investment Grade, (C) – Junk, (FBJ) – Far Below Junk – domestic airline bonds, and finally in the Nuclear Waste (NW) category – Russian Airline bonds.

Why are banks not seeing this and what happened to risk (credit) spreads? My cousin mentioned that several large Russian oil companies just received loans from American and western banks (i.e. Citigroup (C), Goldman Sachs (GS), Barclays (BCS)) at or around Libor plus 25-50 basic points. Let me put it into perspective, this about 1% premium to risk (default) free US Treasury bills. In other words banks are thinking that Russian oil companies are just a bit riskier (1%) than the US Government – the entity that can print money, raise taxes and has nuclear weapons. Is this another case of selective amnesia, similar to sub-prime lending? Will they think it’s not a problem until suddenly (it is always sudden for them) it becomes one? Did banks forget about Russia’s near death experience of the late 90s or the Yukos debacle from 2004?

Lending at a slight premium to a risk free rate made very little economic sense. Any rational entity would have been better off taking the money and buying higher yielding (much higher quality), AAA rated U.S. corporate bonds. But see, big (money center) banks are in the business of making loans. To be more precise, they are in the business of making dumb loans. When the global economy is roaring, all loans are good loans, the risk is a four-letter word that only a few can spell.

As a man with a hammer is looking for a nail, a banker armed with cheap funds is looking to make loans and generate fees. Every time a recession shows its ugly face, the “dumb” loans float to the surface and huge write offs are taken, shareholder equity is lost. During the last recession of 2001, big banks were writing off billions in loans made to South America. In the next recession it will be Russian loans.

Again, why would western banks give loans to Russian airlines that never generated positive cash flows (and probably never will) or Russian oil companies at an almost risk free rate? The answers are very simple: global liquidity and syndication.

An abundance of global liquidity coupled with low interest rates has compressed spreads between investments of various risks. Investors hungry for any yield are garbling up bonds of any risk just to increase the yield of the portfolio. Also, more and more large loans are syndicated among dozen of banks, the risk is assumed to be diversified away. Syndication sounds great in theory, but it increases the system risk as it breeds indifference and a lot of bad loans – just wait a year or two.

This article was originally published on Minyanville.com