Rate Cut May Not Solve Banks' Problems

The Federal Reserve's sneak attack rate-cut Wednesday bounced the bank index to a record high, but the bang in financial stocks may prove premature.

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A rate cut would seem like just desserts for the financial sector, where profits have been squeezed by a series of six rate hikes that started in mid-1999 as the Fed tried to rein in the red-hot economy. But bank stocks have a handful of other issues weighing on them right now -- most noticeably the specter of bad loans -- so the sector has plenty of vegetables to swallow before it can get to the good stuff.

"I don't think this changes things dramatically. Things aren't going to get better overnight [for] companies with fundamental business problems," said Kevin Timmons, banks analyst at FAC Equities in Albany, N.Y. He points to credit problems at companies like Xerox (XRX Quote - Cramer on XRX - Stock Picks), which in turn can hurt banks they borrowed from.

And for months bank analysts have fretted that the economic conditions that could yield a rate cut might also carry the threat of recession as the economy continues to slow. "What is the Fed saying is so scary with a cut at this time, of this magnitude?," says Nancy Bush, banks analyst at Prudential Securities. "I'm not sure [the Fed] can generate demand" with this cut.

Of course, financials will undoubtedly get a boost from the cuts as they take some pressure off the cost of doing business. Not only is it cheaper to borrow money, but also as Bush points out, "it reduces the cost of carrying nonperformers." (Nonperforming assets are loans that are past due but haven't been written off yet.) Timmons adds, "in terms of perceptions, this is unbelievably good."

Banks that engage in consumer lending including thrifts could stand to gain the most particularly since their balance sheets are more sensitive to interest-rate moves than commercial banks' assets. Consumer-based bank stocks bore the brunt of the pain when rates were on their way up, so analysts expect them to gain on the downside, though some of the rate cuts have already been pricing in over recent months.

"My reaction is pretty much mixed," says Bush. "It lightens the mood, but it's not going to keep [certain] types of credits from going nonperforming -- those whose crises were not precipitated by rate events."

The American Stock Exchange Broker/Dealer Index climbed 12.4% to 605.51, while the Philadelphia Stock Exchange/KBW Bank Index rose 5.1%, to 933.75 after hitting an intra-day 52-week high of 935.6.