Banks Facing a Rate-Cut Squeeze

All in all, it's a recipe for what industry people call "net interest income margin compression" -- a situation in which a bank's profit margin from its lending and deposit operations shrinks.

Near-Term Grim

And that's why some bank analysts already are beginning to warn investors not to expect net interest income to serve as a catalyst for earnings growth, at least until interest rates start rising again.

"We forecast that net interest income growth will not be much of a driver of earnings for the banks next year," wrote Goldman Sachs bank analyst Lori Appelbaum, in a research note last week.

In light of that, Appelbaum advised Goldman clients that she was reducing her earnings estimates for the dozen banks she covers by an average of 1% next year, with Wells Fargo feeling a bit more pressure than other banks. She said banks that will excel next year are the ones that do the best job at generating fees from managing money, whittling down the bad loans on their books and cutting operating costs.

Overall, Appelbaum remains neutral on the near-term outlook for the banking sector.

Old Issues

Of course, the threat of margin compression at the nation's banks couldn't come at a worse time, since many big institutions are still coping with a rising tide of bad commercial loans to ailing telecommunications and energy companies.

With banks like J.P. Morgan, FleetBoston(FBF - Cramer's Take - Stockpickr) and Bank of New York(BK - Cramer's Take - Stockpickr) still taking charges against earnings for bad lending, the Fed's latest cut is sort of like rubbing salt in a wound.

If investors feel the need to jump into bank stocks now, the safer bets are probably smaller regional and community banks, which aren't weighed down with a mountain of bad telecom and energy loans.

These smaller players tend to do a better job than their bigger competitors in gathering deposits from small businesses and consumers, and they can better manage a squeeze in net margin interest income. And they are in a position to capitalize on any surge in home refinancings in light of the latest rate cut.

Some names that get bandied about include Keycorp (KEY - Cramer's Take - Stockpickr), Charter One(CF - Cramer's Take - Stockpickr), Sovereign Bank(SOV - Cramer's Take - Stockpickr), Washington Mutual(WM - Cramer's Take - Stockpickr) and Commerce Bancorp of N.J.(CBH - Cramer's Take - Stockpickr).

But overall, the rule of thumb is caution in the banking sector after the Fed's latest move.

"The reaction of bank stocks to go down was the right one," said Stead, whose $680 million fund invests heavily in bank stocks. "It does nothing for the banks. And [it] shows the economy is a lot weaker than we all thought."

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