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The Banking Sector Knocks on Wood

Banks are tiptoeing out of the recession's shadow, but it wouldn't take much to send them back.

Haywood Kelly, 06/29/2010

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

Q: You also recently raised the fair value estimate for Wells Fargo WFC.

A: We have come to expect a lot from Wells Fargo--the company continually outperforms its peers. First-quarter results lived up to our expectations, and favorable credit trends bode well for the balance of the year. Wells Fargo was also very upbeat in its assessment of the economy, suggesting that credit losses peaked during the fourth quarter and would continue to trend downward.

Q: The team recently did a study to see which banks' earnings were benefiting from the timing of their loan-loss provisions. Please summarize the report.

A: Looking beyond management's language, we decided to take a look at the first-quarter numbers and see which banks' bottom lines were helped by underprovisioning for losses and which banks were punished by still building their allowance for loan losses. We found the bigger banks benefited in the first quarter, either matching charge-offs or underprovisioning, while the regional banks continued to grow their allowance. 20% of J.P. Morgan's pretax income was the result of the allowance recapture. On the flip side, the pretax income of BB&T BBT was dragged down 40% by its $100 million allowance build.

This huge difference can be quickly explained by the aggressive nature in which the bigger banks confronted this crisis in the first place. The larger banks--with their credit- card portfolios and national attention--built up their allowance for loan losses far more than the typical regional bank and consequently have a larger gap between their current allowance and their typical long-term allowance level. In other words, the big banks punished their income statements to a greater degree on the downside and are now recognizing the upside earlier. While quarter- to-quarter metrics may change, we expect with continued economic improvement by the end of 2010 most banks will see their charge-offs exceed their allowance for loan losses, giving their bottom-line numbers a rapid and much-needed boost.

Q: Are you worried about commercial real estate being the next shoe to drop?

A: US Bancorp USB, BB&T, and Regions Financial RF have the greatest exposure to commercial real estate problems. While the data give us some mixed signals, we believe that the commercial real estate cycle will be manageable for most of the large banks but will lead to the demise of some smaller players. We expect loan losses from commercial real estate to peak sometime in 2011. Higher capital levels will help absorb these losses and should not require any of the top 10 banks to see additional capital.

Q: What about exposure to commercial mortgage-backed securities?

A: CMBS are not a major concern for any bank, with the possible exception of PNC PNC. Commercial real estate loans inside of CMBS tend to be to larger, more-established firms, because the smaller, more marginal loans gravitated toward smaller community banks that did not have the capability to securitize the loans. However, underwriting standards on CMBS loans weakened considerably between 2002 and 2007 before the market basically shut down.

Q: As with most sectors, there are few 5-star bank stocks at the moment, given how far the market has rebounded. Are there any banking stocks you'd recommend now?

A: None that have 5-star Morningstar Ratings, but we like Bank of America, which has a 4-star rating. We recently raised our fair value estimate for Bank of America to $25 from $23. We expect consumer loan losses to peak in mid-2010 and commercial losses to peak in early 2011. We expect the company to continue to provision less than its charge-offs, reabsorbing some of its allowance for loan losses and temporarily boosting the bottom line. Consequently, we expect earnings to rebound sharply after the peak, even if the economy does not bounce back as quickly.

Q: You'll be launching credit ratings for banks in the second quarter of 2010. Can you describe your methodology?

A: The approach is similar to Morningstar's general methodology for credit ratings in that it assesses credit quality in four independent ways. But given that banks are unique animals, each of those four metrics is custom-tailored. We calculate the Morningstar Business Risk and Distance to Default scores in a way similar to the way Morningstar calculates them for general companies, but there's no Cash Flow Cushion measure. Instead, we test a bank's capability to absorb losses by applying relatively high standard loss rates across various asset classes on a bank's balance sheet.

Q: Do you have an equivalent to the Solvency Score?

A: Yes. The banking Solvency Score ranks banks quarterly on a relative percentile basis according to measures of capital, asset quality, earnings power, and liquidity.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.

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