Why Bankers Keep Seeing Bears

Their stocks have been strong this year, but now earnings are under assault

You wouldn't know it from their stock prices, but banks are bracing for bad times. Not long ago demand for mortgages was strong, profit margins were fat, potential acquisitions were reasonably priced, and regulators were off their backs. No such luck these days. The tide is turning so dramatically that some analysts are downgrading the entire sector.

Third-quarter results were underwhelming for banks of all stripes--from tiny community enterprises to the biggest global players. On Oct. 25, the small Portland (Me.)-based TD Banknorth (BNK ) Inc. reported a 3% decline in third-quarter profits, to $86 million, blaming the interest rate environment and an uptick in bad loan reserves. Less than a week earlier, financial-services giant Citigroup (C ) reported that third-quarter net income fell 23% as corporate and investment bank revenues dropped.

Tune in to any random earnings call and you'll hear bank executives sounding bleak. Regulators are admonishing them for high concentrations of risky commercial loans and less-than-savory sales practices for mortgages. Fee income from underwriting and merger advice has been mostly flat, and the credit quality of existing borrowers is expected to deteriorate. "There's no sign of the pressure abating," says analyst Peter J. Winter of BMO Capital Markets, who cut his 2007 earnings growth estimates for large regional banks to 9% before the third-quarter numbers were in, and again to 7% after seeing the actual results.

Despite the heady run for bank stocks--the KBW Bank Index hit a 52-week high on Oct. 4--large regional banks have been the worst performers of all the financial companies in the Standard & Poor's 500-stock index since July. Blame interest rates. The difference between what banks must pay to borrow money and what they can charge when they lend it out to customers is shrinking, squeezing profit margins. "Margin pressure has accelerated, and [banks have] drawn down on loan loss reserves for income," explains Steve Rayner, portfolio manager of the $300 million ING Financial Services Fund, which invests in mid-cap and large-cap banks, as well as thrifts. "That can't continue forever."

At the same time, competition for basic deposits is also crimping business. In the third quarter, most of the 50 largest banks struggled with deposit outflows as higher short-term rates lured customers into certificates of deposit, money markets, and brokerage accounts that pay customers more than checking accounts, and therefore cost the bank more to stay competitive. "There used to be oodles of deposit growth at minimal cost, and banks were flush," says Jacqueline Reeves, senior analyst with Ryan Beck & Co. "Deposit growth is now tougher to come by, so banks have to pay up."

PADDING PROFITS?

The valuation picture isn't rosy, either. For the top 50 banks, the p-e ratio of 13.6 for the forward 12 months is 88% of the broader market's multiple of 15.5; normally it's 70%. "I'd be cautious about buying bank stocks," says Frederick Cannon, San Francisco-based managing director for Keefe, Bruyette & Woods Inc.

The wild card is credit quality. What worries David Ellison of the $400 million FBR Small Cap Financial Fund (FBRSX ) is potential credit problems stemming from overburdened consumers and, especially, homeowners. Many banks, including Capital One (COF ), Bank of America (BAC ), and Fifth Third, (FITB ) have already warned investors that they expect consumer credit quality to worsen. But by how much? "We're definitely going to be bouncing around the bottom for a while, adding volatility to earnings," says Reeves, who recently lowered her 2007 earnings estimates for 17 thrifts by an average of 3%. "We're going to see more and more charge-offs."

Some banks and mortgage players, such as Washington Mutual (WM ) and Countrywide Financial (CFC ), have recently announced cost cuts. Others are restructuring their balance sheets by selling off securities: Bank of America, for example, announced with third-quarter earnings that it would reduce its securities portfolio by $100 billion over the next several years. Analyst Dick Bove of Punk, Ziegel & Co. notes many banks are easing the pressure by lowering their effective tax rates with financial engineering. Bove writes in an Oct. 25 research report that 32 of the 47 banks reporting by that date saw drops in tax rates in the third quarter, thereby padding profits. It was no coincidence, in his view. "This is an eye-opener for those who do not believe that banks manage their earnings," he writes. "The key question is: How many more quarters will these companies be able to cut costs, reduce tax payments, and buy back stock if revenues keep falling?" His answer: not many.

Consolidation may be the ticket out of short-term doldrums. If the climate continues to be challenging, Winter says, more banks might be willing to sell. While the recent stock run makes acquisitions more expensive, it also gives banks an inflated currency with which to go shopping. "The big thing to watch next year is M&A activity," he says. Adds Cannon of KBW: "What could temper any investor bearishness is consolidation. Oftentimes when banks see their operating environment deteriorate, it's a pretty good time to find a partner."

By Mara Der Hovanesian

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