Better Credit Quality Should Boost Banks' Q2 Earnings

Lower losses from nonperforming loans should help lift second-quarter profits, offsetting subpar investment results

By David Bogoslaw

(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.

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