Bullish Quarter for Banks?

Standard & Poor's analysts survey the sector's prospects as big players get ready to report. One clue: Keep your eye on credit quality

A number of major financial firms will report fourth quarter earnings results starting this week. When the reports roll in, investors will focus on how interest rates and the health of the credit environment are affecting the companies. Standard & Poor's has an overweight opinion on the financials subindustry.

S&P equity analyst Frank Braden expects a small negative effect from the interest-rate environment, but doesn't expect much of a change from deteriorating credit for the large banks. Braden sees the majority of large banks coming in slightly ahead of estimates, particularly those banks with investment-banking activities.

For individual earnings reports, Braden will be looking to see how substantially net interest margins have been affected by the flat yield curve environment. In this type of environment, it's important for the large banks to maintain strict cost containment. In addition, non-interest expense will be a large focus. Another issue is whether the credit environment—in cards and mortgages—is starting to have a material effect on the bottom line.

High-End Results

One bank Braden covers, Wells Fargo (WFC; S&P investment rank 3 STARS, hold), reported results on Jan. 16, posting fourth quarter earnings per share that came in just shy of his forecast. Braden said Wells Fargo's results were hurt by a decline in home-mortgage revenue, as well as worse-than-expected performance in its auto-lending business.

Other large banks expected to report in the days to come include: Citigroup (C; 5 STARS, strong buy), Bank of America (BAC; 5 STARS), and Wachovia (WB; 5 STARS).

For consumer-finance companies—such as Capital One (COF; 4 STARS, buy), American Express (AXP; 3 STARS), and AmeriCredit (ACF; 4 STARS)—Braden expects a solid consumer-credit environment to help results to come in at the high end of analyst expectations.

But Braden will be watching closely for signs of deterioration in the credit environment. With regard to Capital One, an important factor will be its credit experience in Britain, which has been a drag on the company recently. Braden expects American Express to hold up better in a difficult credit environment due to its more affluent clientele. AmeriCredit, a sub-prime auto lender, would likely be a leading indicator of any deterioration in consumer credit.

Inverted Yield Curve

S&P equity analyst Stuart Plesser believes the fourth quarter will be a tough one for regional banks and thrifts, with earnings likely to remain flat or decline slightly from third-quarter levels. However, he believes that the stock price performance of these names will most likely be driven by the market's perception of whether the Fed will reduce the fund's rate in 2007.

The yield curve has remained inverted for the duration of the fourth quarter with the spread between three-month Treasury bills and 10-year Treasury bills averaging about 30 basis points. This, in turn, probably continued to pressure net interest margins, favoring those banks and thrifts that have a lower cost-funding basis.

Plesser doesn't believe loan growth will offset net interest margin pressure, as competition for loans remained fierce. This, combined with a slowdown in the economy, may well result in a moderation of loan growth.

Separately, credit quality deteriorated in the fourth quarter resulting in higher charge-off levels, and as a result, provisions will likely rise from third-quarter levels. Although expense reduction has probably run its course for most thrifts and banks, there are exceptions, such as Washington Mutual (WM; 3 STARS) and Sovereign (SOV; 3 STARS), as both thrifts recently undertook aggressive expense reduction measures.

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