Better Credit Quality Should Boost Banks' Q2 Earnings

(Corrects name of Polaris Capital Management in the fourth paragraph.)

While the largest European banks are under the microscope amid stress tests gauging their exposure to sovereign debt, most U.S. banks appear to be out of danger a year after having to run their own financial-health gauntlet. Analysts and investment strategists believe loan loss provisions at U.S. banks may have peaked, while net interest margins are improving as older certificates of deposit at higher rates mature and are replaced with much lower-yielding ones.

Bank earnings for the second quarter will be driven mostly by lower credit costs, including net charge-offs for nonperforming loans and loan loss provisions. Some banks will benefit from increased mortgage origination and higher revenues from payments processing, but these will likely be offset, partially if not fully, by a bigger-than-expected impact of volatile capital markets, which will depress investment revenues, JPMorgan Chase said in a June 30 research note.

The current earnings forecast for the 24 companies in the KBW Bank Index (BKX) is $12.11 billion, up 211.6 percent from aggregate earnings of $3.89 billion in the second quarter of 2009, according to Bloomberg data. The KBW Bank Index includes most of the largest money-center banks such as JPMorgan Chase (JPM) and Bank of America (BAC), as well as super-regional banks such as BB&T (BBT) and PNC Financial Services Group (PNC).

Loans Still Pose a Threat

The declining pace of loan delinquencies over the past couple of quarters has bought banks time to work through some of their problem loans, but the threat of nonperforming loans is far from over, says Bernard Horn, president of Polaris Capital Management in Boston. Although loan loss provisions, or the amount banks set aside for bad loans, have exceeded net charge-offs, or the amount of losses taken on soured loans, for a few quarters, he worries about whether the value of bad loans has been written down enough to not require further write-offs when banks eventually liquidate their portfolios. Horn believes banks have not addressed a lot of the underwater commercial loans they hold, auguring more write-offs in the future.

In a July 2 research note, Credit Suisse (CS) predicted improvement in banks' consumer businesses would potentially be offset by commercial loan portfolios, "which we think could be lumpy and vary by bank." Credit Suisse is projecting a 3.0 percent rise in nonperforming assets for U.S. banks, after a 1.0 percent decline in the first quarter, and a 1.0 percent increase in net charge-offs, vs. a 3.0 percent decline in the first quarter. Growth in nonperforming assets will probably be higher at companies such as Wells Fargo (WFC) and PNC Financial that are still integrating big acquisitions, the note said. Credit Suisse forecasted loan loss provisions to drop 2.0 percent on average from the first quarter, vs. a 20 percent drop from the elevated level in the fourth quarter of 2009, and a lessening in capital reserve builds due to signs of stabilization in consumer credit quality trends.

After the market close on July 7, Wells Fargo announced it was folding its Wells Fargo Financial Consumer Finance division into its traditional branch network, closing 638 financial stores and exiting the origination of nonprime mortgage loans. The company expects that to result in $185 million in pretax charges, $137 million of which will be taken in the second quarter and most of the balance in the third quarter. That will translate to a 2-cent hit to Wells Fargo's second-quarter earnings, according to a July 7 research note by Sandler O'Neill & Partners.

Weaker Trading Results

For large banks with capital markets exposure, weaker trading results will likely cause a 10 percent decline in revenues on average from the first quarter, Credit Suisse said. In a June 17 research note, Credit Suisse lowered its full-year 2010 earnings forecasts for Bank of America, Citigroup (C), and JPMorgan Chase by 4.0 percent on average based on weaker trading revenues and anemic net interest margins.

Revenues from payments processing in the second quarter could rise more than warranted by the normal seasonal improvement as suggested by positive remarks from American Express (AXP) and Visa (V), pointing to favorable consumer spending trends, according to the JPMorgan Chase note. Among the banks covered by JPMorgan analysts, U.S. Bancorp (USB) would be the biggest beneficiary of this, the note said.

The biggest pressure on bank profits right now is extraordinarily high premiums being required by the Federal Deposit Insurance Corp. to insure deposits, says Horn at Polaris. A bank that was paying premiums of about $500,000 before the financial crisis can be paying as much as 10 times that amount now. "That's hurting the smaller banks that fundamentally didn't get into trouble and didn't have problems but are picking up the tab for the [larger] ones that did," he says.

Bank earnings should return to normal levels once FDIC premiums start to come back down, but that could take a couple of years, he says.

Mortgage Market Challenge

Another major challenge stems from the fact that the federal government is effectively controlling the residential mortgage market, says Horn. Since banks can't afford to compete with the government for home buyers' business, given how low lending rates are and the fact that the Federal Reserve guarantees those loans, a lot of banks have been pushed to rely more heavily on commercial loans for income, exposing their balance sheets to more risk than usual, he says. That's affecting banks of all sizes.

The outlook for commercial real estate loans remains unclear in view of their dependence on employment growth, says Erik Oja, an analyst at Standard & Poor's Equity Research who covers regional banks. The more people employed, the higher the occupancy of office buildings and retail malls—and the easier it is for owners of those properties to make their mortgage payments.

His main concern is whether the economy can grow at the pace needed to create enough new jobs. "I don't see the rate of improvement I was originally hoping for," he says. "A lot of mid- to small-sized businesses are very hesitant to expand and are not able to get the credit they want." The threat from nonperforming commercial loans would be magnified if the U.S. economy weakens, which he currently doesn't anticipate.

Oja says he generally would expect revenues and fee income—including service charges on deposits, insurance, brokerage accounts, and mortgage banking, as well as gains and losses on securities—to be significantly higher than in the second quarter of 2009, which was still a fairly weak period. He also expects loan loss provisions to have declined in the last three months.

Commercial Construction Loans

He says he's wary of any regional bank whose commercial construction loans—the riskiest of the four kinds of commercial loans—account for more than 7.5 percent of the total loan portfolio, especially in distressed regions of the U.S. such as the Southwest and Southeast. At 21 percent, Wilmington Trust (WL) is one of the banks to be most cautious of, he says.

In a July 6 note, Macquarie Equity Research said it raised its second-quarter net charge-off assumptions for Wilmington to $100 million from $28.9 million and increased its loan loss provision expense estimate to $125 million from $50 million based on a third-party portfolio review being conducted and a slower economic recovery. Macquarie cut its second-quarter earnings forecast to a loss of 87 cents from a loss of 20 cents per share on higher provision expense, a shrinking balance sheet, and lower fee income. The added credit stress will postpone repayment of the money Wilmington received under the Troubled Asset Relief Program (TARP) from the fourth quarter of 2010 to the second quarter of 2011, which will put more pressure on earnings per share this year and the first half of 2011, according to Macquarie.

Among the regional banks with the lowest percentages of commercial construction loans, says Oja: Bank of Hawaii (BOH), TCF Financial (TCB), and Fifth Third Bancorp (FITB).

While bank balance sheets can't expand meaningfully until banks step up lending, they have good reason to be overly conservative in their lending practices right now, says Oja. If the Financial Accounting Standards Board rules that starting next year banks have to start marking to market all loans held to maturity, banks recognize that they'll be required to raise additional capital. Their capital requirements might also rise if a new set of international banking standards currently being worked on materializes, he adds.

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