Banks: Merrill Brings the Gloom

This earnings season could be brutal for U.S. banks, the continuation of a banking crisis that could last for years. That’s the implication of a new report from Merrill Lynch (MER) analysts, who say large regional banks could see 2008 and 2009 earnings per share nearly one-quarter below what analysts are now expecting. The banks in question include Bank of America (BAC); Fifth Third (FITB), which announced plans to raise $2 billion in capital this week; KeyCorp (KEY); National City (NCC); Regions Financial (RF); SunTrust (STI); U.S. Bancorp (USB); Wachovia (WB); and Wells Fargo (WFC). Several key points from this 54-page report, which is sending bank stocks plunging today: 1. It’s all about credit quality. Banks’ borrowers are having a harder time paying off loans “across nearly all consumer and commercial loan categories,” the Merrill analysts, led by Edward Najarian, write. The worst credit quality will be in residential construction and home equity loans. Of those, the worst hit will be in areas hit hard by the housing slowdown, namely California, Florida, Arizona, Nevada and Michigan. Also, loans originated by brokers are in far worse shape than loans originated by the banks themselves. 2. “Bank stocks now appear to be in capitulation mode.” The gloomy mood, risky credit, uncertain earnings, dividend cuts and capital raising have sent banks stock prices down more than a quarter in the past seven weeks, and could “trade below fair value in the near-term.” 3. This earnings season will be rough. For large regional banks, Merrill is predicting median bank earnings in the second quarter of 18% below estimates. Wachovia and Bank of America could miss Wall Street expectations by the greatest percentage.

Last quarter, big banks benefited from profits from the initial public offering of Visa (V) (because they used to share ownership of the credit card network.) That revenue won’t be boosting earnings this quarter. The other problems will be “higher net credit losses” and a greater need to build up reserves for future losses. Revenue trends, however, “will be solid,” with strong commercial loan growth at most banks. 4. But the problem is long term. “We don’t expect credit metrics to begin to recover until 2010.” 5. Cash is still king. That’s the conclusion of the Merrill analysts , who expect more rounds of capital-raising and dividend cuts, as banks need cash to prepare for loan losses. Merrill predicts dividend cuts and/or capital-raising at Bank of America, Regions Financial, SunTrust and Wachovia in the second half of the year. 6. Raising capital will get tougher. The problem with raising cash going forward, Merrill warns: Because stock prices have fallen so much since the beginning of the year, banks will have to issue more new shares to raise the same amount of money. This dilutes existing shareholders’ stakes even more than previous capital-raising efforts. Recently, the stock markets reaction to new issuances has been brutal, often cutting prices 20% to 25% on the day they were announced. Some of my thoughts on the Merrill report:

It’s tough to predict how bad credit quality will get. It’s true that the full effects of a weak economy haven’t yet shown up in credit measures. The housing market does seem worse than at any time in recent memory, but the job market, with an unemployment rate of 5.5%, isn’t that bad compared to previous banking crises. The report notes that as banking stocks fall, “we should get closer to fully discounting the credit cycle in bank stock prices and commencing a sustainable price recovery.” This reminds me that I heard a commentator say on TV this morning that he expects the financial sector to be a great investment in “three to five years.” I’m all for a long-term investment horizon, but there are real dangers to making a long-term value bet on financials. A “sustainable price recovery” might have to wait for a long time, as other sectors could provide much better returns in the next few years. Also, even for long-term value investors, there is a big difference between a payoff in three years and a payoff in five years. If you think credit conditions are better than these Merrill analysts’ assessments, banking stocks might be a great investment for you — if not now than later this year. But if these analysts are right, this sector will remain a no-man’s land for quite a while. After all, why invest in financial stocks in 2009 if the recovery in credit conditions won’t come until at least 2010? There are real dangers to being early, particularly if credit problems drag on even longer than expected.

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