Banking: Bracing For The Squeeze

-- Earnings growth from financial services is set to slow as interest rates escalate -- With companies lean from cost-cutting, mergers could provide the next profit surge

For many financial-service firms, an era of easy profits ended a few years back when the stock market bubble popped. Their salvation was the Federal Reserve's decision to slash interest rates to their lowest levels in decades. For banks, the plunge in rates triggered an unexpected boom in mortgages and refinancings that many institutions rode to record profits. And on Wall Street, the rate cuts enabled investment firms to generate enough profits from bond trading to offset partially a decline in merger and stock-related activity.

But what the Fed giveth, the Fed taketh away. Now the financial-services industry finds itself struggling to adapt to rising rates. The trend will carry through 2005, given that the Fed is expected to push rates up by another full percentage point in the coming year. Bank profits are already being squeezed by tighter lending spreads, as well as by the 26% plunge in mortgage activity over the past year. Lenders will be squeezed further in the new year, given the Mortgage Bankers Assn.'s prediction that mortgage lending will drop by another 18%, to $2.3 trillion.

And while banks have been able to offset those declines because of the brisk growth in home-equity lending, analysts are nonetheless bracing for a sharp slowdown from the 15% profit growth banks recorded last year. Andrew B. Collins, banking analyst for Piper Jaffray & Co., (PJC ) expects overall bank profits to expand 10.5% in 2005. Other Wall Street pros believe it may turn out to be even less than that. "The profit outlook for banks is not as bright as some might think," says Thomas K. Brown, chief executive of Second Curve Capital, a New York hedge fund specializing in bank stocks.

The rise in rates is also being felt on Wall Street, where profits were already down a collective 19% in 2004, according to Securities Industry Assn. (SIA) estimates. With merger activity and stock underwriting still well off the levels of the late 1990s, many investment banks have been able to stay in the black thanks to hefty gains in their proprietary trading in bonds. But with rates on the rise, Brad Hintz, an analyst for Sanford C. Bernstein & Co., predicts that the profits earned from proprietary trading by the major Wall Street firms will dip by 12% in the new year. The decline in such trading would be much worse, except that analysts believe the major Wall Street banks will be able to offset the expected declines in bond activity with a pickup in commodities trading. For example, continued volatility in oil, gas, minerals, and other raw materials will lead to greater demand for hedging strategies from big commodities buyers.


With the trading picture mixed, Wall Street firms are depending on a rebound in their mainstay investment banking activities. On the underwriting front, the business of taking stocks public will be muted. While Wall Street underwrote $64 billion in new domestic stock issues during 2004, Hintz believes that underwritings of initial public offerings could dip to $60.5 billion in 2005.

The reason? Sarbanes-Oxley rules, which require that top executives of public companies certify the accuracy of their financial statements, are discouraging many development-stage companies from listing. Wall Street bankers -- more mindful, following New York Attorney General Eliot Spitzer's probes, of their own liability in underwriting dubious IPOs -- are exercising far more discretion as to which companies they take public.

On the mergers-and-acquisitions front, though, there's reason for hope of a further rebound. Economic growth is expected to throttle back in 2005, and companies have already slashed their cost structures to the bone. Many investment bankers believe that Corporate America will come to view mergers as one of the best ways to drive profit growth over the next couple of years. Already, Wall Street is taking heart from the relatively warm reception that investors gave to Johnson & Johnson (JNJ ), for its $25 billion deal to buy device maker Guidant Corp (GDT )., and to Sprint Corp (FON )., following its $35-billion merger with Nextel Communications Inc (NXTL ). "Clearly, the markets are receptive to M&A transactions," says David Goldfarb, chief administrative officer at Lehman Brothers Inc. (LEH )

As a result, the value of announced deals, which in 2004 rebounded 40%, to $741 billion, could surpass $1 trillion in 2005, believes Frank Fernandez, chief economist for the SIA. Given the improving M&A outlook, Hintz believes that Wall Street profits could rise 8% to 9% in the new year. "2005 is going to be a somewhat better year," he says, "but not the gangbuster year that everyone had hoped for."

For the banking industry, the key to 2005 will be whether it can stoke demand for new lending. So far, companies have been reluctant to borrow, and with plenty of cash on hand -- the S&P 500 companies alone are sitting on a stash of more than $590 billion -- they haven't had to. That's why Collins expects commercial lending will rise by a modest 3% to 5% in 2005. And any lending that does occur will become increasingly competitive. "Pricing has been cutthroat," notes Fari Kahn, a vice-president at Loan Pricing Corp., a New York research firm.

So, banks are likely to keep the credit spigot wide open to consumers, and this could cause trouble as interest rates rise. Analysts are warning that rising rates could increase defaults among mom and pop borrowers, who have taken on massive levels of debt during the long housing boom. Still, bankers remain sanguine that their consumer portfolios will be sound as long as the economy remains strong and job numbers don't head south. "The consumer is doing just fine," Richard M. Kovacevich, CEO of Wells Fargo & Co. (WFC ), recently told analysts. "There won't be any serious credit quality issues unless unemployment gets well over 6%."

With bank profits expected to slow and the mortgage boom fizzling, the banking industry could see a mini-wave of consolidation in 2005. There won't be as many megadeals as in the last period, but analysts expect the big players to go on the hunt for smaller regional banks to help fill in their maps. "Acquirers aren't able to grow earnings the old-fashioned way because loan demand just isn't there," says Nick Studer, head of consultant Mercer Oliver Wyman's corporate and institutional banking practice. "So how do you grow earnings? You start merging." That's the simple reality in an era of rising rates.

By Dean Foust in Atlanta, with Emily Thornton and Mara Der Hovanesian in New York

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