Banks Aren't Yet in the Clear

Analysts see several reasons why the recent strong earnings reports by the likes of Wells Fargo and Goldman Sachs may not be repeated

A few months ago, a teetering U.S. banking system seemed ready to take down the global economy. Now the stocks of the biggest banks have been on a tear, following rosy earnings announcements by Wells Fargo (WFC) and Goldman Sachs (GS).

But the strong first-quarter numbers may not be as strong an omen as they seem. Analysts expect a good chunk of the industry's gains to prove fleeting, leaving banks to grapple with the grim economy and investors to deal with stock market fallout. "Bank earnings benefit from a number of things that don't have a lot to do with fundamentals," says Fred Cannon, chief equity strategist at investment bank Keefe, Bruyette & Woods (KBW).

Consider the refinancing boom, which was triggered by record-low mortgage rates. The flurry of activity helped propel Wells to a $3 billion gain this quarter and will likely boost other banks as well. But the trend may quickly peter out since there's a limited pool of people who can refinance their loans. Among the borrowers who don't typically qualify: the one in five owners who are underwater on their mortgages, meaning their homes are worth less than their loans.

The record-low rates are goosing bank earnings in other ways. Many banks service the mortgages in large investment pools, collecting homeowners' monthly payments and distributing them to investors. The value of those servicing contracts go up and down, and banks buy securities to hedge against those movements. When rates fall, the securities can rise in value, often faster than the banks mark down the value of the contracts. In those cases, banks book profits.

Hard to Repeat Gains

That mismatch, says Ed Najarian, head of bank research for institutional broker ISI Group, probably helped Bank of America (BAC) and Wells in the first quarter. But such gains are hard to repeat. "While [Wells'] mortgage revenue will stay strong at least in the second quarter, they're unlikely to get another hedge gain," Najarian says. A spokeswoman for Wells Fargo, which plans to release more details about its profits on Apr. 22, declined to comment. A spokesman for BofA declined to comment ahead of the bank's Apr. 20 earnings announcement.

New accounting rules may have come to the banks' rescue as well. Early in April, banks got the O.K. to use their own judgment in valuing assets, rather than relying on depressed market prices. The result: Banks may have raised the value of their toxic assets in the first quarter, thereby increasing earnings. "You could have paper gains that are offsetting real losses during the period," says Donn Vickrey, co-founder of research firm Gradient Analytics.

Then there's case of Goldman Sachs' missing month. On Apr. 13, the bank reported eye-popping profits of $1.8 billion for the first quarter. Not bad, but Goldman switched to a calendar year from a fiscal one ending Nov. 30. That meant December, and its $780 million loss, was an orphan—omitted from the results for both the full fiscal year of 2008 and the first quarter of 2009. A Goldman spokeswoman said the company was required to switch to a calendar year when it became a bank holding company last fall.

Fundamental Uncertainties

Nonetheless, analysts are raising doubts about whether Goldman's profits will persist. The trading unit accounted for much of the gains, while the other groups remain lackluster. "Given the extent to which [Goldman's] earnings was concentrated…coupled with weak economic conditions and capital markets turmoil, we believe it would be premature to conclude that a sustained turnaround is under way," Scott Sprinzen, an analyst at Standard & Poor's (MHP), said in an Apr. 14 report.

Bank earnings aren't entirely flimsy. The growth in customer deposits could prove lasting. Banks can also borrow at close to 0% from the Federal Reserve and lend money at much higher rates, profiting handsomely on the difference. A few firms, including JPMorgan Chase (JPM), may take the quarter to increase reserves for bad loans, sacrificing profits to bolster their books.

The earnings pop comes in the nick of time: Officials have been putting big banks through their paces, analyzing the results of "stress tests" to gauge how banks will fare in a worsening economy. The prospect of healthy profits may reassure regulators that a bank can replenish its capital, unaided over time. (The U.S. could release details in early May.)

Still, banks remain plagued by fundamental uncertainties—chiefly the toxic assets that they have been unable or unwilling to shed. Ultimately, sustainable earnings will depend on the health of the economy. "The economy needs to stabilize," says James Cassel, vice-chairman at investment bank Ladenburg Thalman. "I don't think we've hit the bottom yet."

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