By Amey Stone Need some cheering up? Investors have plenty of reasons to be gloomy, given the contracting economy, vulnerable financial markets, and great national uncertainty about upcoming military action. But investors should consider one important bright spot in the financial world before they get too morose: America's banks are in great -- yes, really great -- shape.
Banks are so profitable lately that even if earnings decline and credit quality deteriorates, they should still make boatloads of money. Core earnings for banks were $115 billion last year, and the costs of providing credit were about $25 billion, according to Moody's Investors Service. In a Sept. 21 conference call on the state of the industry, Moody's analysts said they didn't expect to take any rating actions as a result of the Sept. 11 attacks -- which they most certainly would have done if the system were vulnerable.
"Banks have a vastly improved earnings profile vs. that of the last recession," says Greg Bauer, managing director for banking at Moody's. "There is ample room for deterioration for both core earnings and credit costs without the credit profile of the industry deteriorating."
HEALED. Furthermore, banks are remarkably well-capitalized, so they're in fine shape to absorb the blow should businesses and individuals start defaulting on loans. On that score, analysts say essentially no grounds exist for comparing the current state of the banks' balance with the way they were during the 1990-91 recession. "They have had a chance to heal their balance sheets from the early '90s," notes Salil Mehta, an analyst with bankstocks.com.
That's not the only reason banks are stronger now. "They are also better managed and more diversified," says Mehta. Thanks to deregulation, they're in a lot of businesses other than banking, and those businesses are spread across much wider geographic areas. That helps protect them when they're hit by major losses in one part of the country.
Another plus for banks: It's not just that they're strong enough to withstand a weakening economy. They should actually benefit from the current interest rate environment and be able to continue to increase earnings this year and in 2002. Short-term rates have fallen sharply as the Federal Reserve continues its efforts to buoy the economy. But because of the worsening economic outlook, long-term rates remain stubbornly high.
COMFORTABLE SPREAD. For banks, that means they can pay less interest to depositors and less for the short-term money they borrow from the Federal Reserve. At the same time, they haven't had to whittle down the interest rates they charge for longer-term loans they make to businesses and consumers.
Consider this: The federal funds rate -- what banks charge each other for overnight loans -- has dropped about 3 percentage points this year (from 6% at the start to 3% now). During the same period, 30-year fixed-rate mortgages have dropped only 1/3 of a percentage point, from 7.04% in January to 6.72% now, points out Raymond James analyst Richard Bove. The widening spread between short and long rates provides a major kick to banks' net interest margin.
"That is nirvana to a bank," Bove says of the bigger spreads. "It means funding profits in the industry are going to be explosive." He expects interest rate cuts to add $40 billion to industry pretax profits in the next two years. "They won't earn all that," he says, since he thinks greater loan losses will subtract $10 billion to $12 billion. But that's still a potential 20% boost to earnings in the next two years.
If bank earnings increase by the 6% to 8% this year and 12% to 15% next year that Bove expects, he thinks the industry may post the fastest earnings growth of any in the Standard & Poor's 500 (except, perhaps, defense). Yet the stocks are still much less expensive than the average for the S&P 500, which, Bove says, "means they are dirt cheap."
LOANERS. The big caveat in this is that all banks aren't created equal. In fact, as banks have diversified beyond the traditional business of collecting deposits and making loans, it has become a lot tougher for investors to pick the bank stocks that will actually benefit from the rate spreads. "A bank is not a bank anymore," points out Diana Yates, A.G. Edwards banking analyst, who says she has been repeating this mantra for years.
Bove says banks that have major loan portfolios, especially mortgage loans rather than commercial loans, are the best buys. He upgraded Washington Mutual (WM) on Sept. 28 and recommends Astoria Financial (ASFC), which own a lot of mortgages. He also strongly recommends SunTrust Banks (STI), SouthTrust (SOTR), and Regions Financial (RGBK), which have more commercial loans.
He warns that what he terms "product banks," like Citigroup (C
), J.P. Morgan Chase (JPM), and FleetBoston Financial (FBF), which often package their loans into securities and sell them, will be hurt in the near term as the bear market in stocks continues. Yet, in the longer term (the next 6 to 12 months), Bove expects the economy to turn around, thanks to all the stimulus from the Fed and increased government spending, which should lift the broader market and boost the product banks as well.
CONFIDENCE IN CONSUMER. From another point of view, Mehta says the team at bankstocks.com is betting that the consumer will hold up better than expected in the downturn. They recommend consumer-finance companies, including Capital One Financial (COF), AmeriCredit (ACF), and NextCard (NXCD), all which they feel have been unduly punished in a brutal environment for equities and are good buys now.
They also like thrifts like Sovereign Bancorp (SOV), TCF Financial (TCB), and First Republic Bank (FRC). While a booster of diversification, Mehta says the biggest banks, like Citigroup, J.P. Morgan Chase, and Fleet, had become too much so for his tastes. "We believe the smaller, more focused companies can outperform and out-innovate their larger peers," he says.
Yates, however, is recommending Citigroup and J.P. Morgan Chase for more aggressive investors, because she thinks the lower interest rate environment will benefit them by boosting the economy. That doesn't mean she thinks their earnings won't suffer near-term. In fact, she just cut her targets on Citigroup. As more defensive plays, she recommends Bank of New York (BK), Northern Trust (NTRS), and Wilmington Trust (WL).
If you think the economy won't recover next year, this probably isn't the best time to buy bank stocks. But Harry Milling, a bank analyst with Morningstar, believes the economy will begin to improve by the middle of next year, which makes bellwether Citigroup, for one, a good buy right now, he says. And even if you don't want to buy any stocks right now, in times of such great uncertainty, it may be comforting to know that the banking industry forms a solid pillar of the nation's financial system. Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.
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