The Banking Sector Knocks on Wood

The banking sector, so key to the well-being of our economy, is on the rebound. Bank stock prices are still below 2007 levels in most cases, but many have returned 100% or more over the past year. I recently checked in with members of Morningstar's banking team --Matt Warren, Jaime Peters, James Sinegal, Erin Davis, Maclovio Pina, and Michael Kon-- to see how the healing process is coming and whether we're out of the woods.

Q: Financial stocks have rallied hard over the past year. How are the fundamentals looking?

A: The mood in the sector has markedly improved from last year. Most importantly, recent data suggest that, after a long and painful climb up, new defaults on mortgages and consumer loans are finally declining. While commercial real estate remains a serious headache for many banks, the improvement in mortgages and consumer loans is likely a harbinger for a turn in the credit cycle. This means that banks with sizable consumer loan books might soon benefit from lower credit costs.

Q: How did bank profits look in the first quarter?

A: J.P. Morgan JPM started off this earnings season with strong results in investment banking and positive news on the consumer loan loss front. Bank of America BAC quickly followed suit, showing lower consumer loan losses and benefiting from strong results at Merrill Lynch. Despite the positive signs in consumer loan losses (early stage delinquencies are down in pretty much every loan category), however, J.P. Morgan's management remained cautious about the upcoming year. We don't blame it. The stability in the housing market could disappear if interest rates start to trend up or unemployment continues to rise. Foreclosures are actually set to increase as customers either flunk out of or fail to qualify for modification programs.

Q: What about Citigroup C?

A: Credit losses remain sky-high at Citigroup, but delinquencies are trending downward, giving hope for the future. Citigroup charged off $8.4 billion of loans this quarter, an annualized run rate of 4.65% on its $722 billion of loans. However, compared with the company's $50 billion in reserves (or 6.8% of total loans), any sign of improvement is likely to allow the company to reduce its provisions going forward, giving a nice boost to earnings later this year.

Overall, Citigroup turned in a decent quarter, given the current economic environment. Capital is strong. (Citi's Tier 1 common ratio stands at a whopping 9.1%.) We expect that earnings will remain in positive territory, barring a double dip in the global economy. However, shares outstanding have gone from roughly 5 billion to 29 billion, leaving no doubts that this crisis and Citigroup's poor management leading into it have permanently damaged shareholders.PAGEBREAK