Safety May Not Lie in Banks

Betting on banks is getting tricky.

Bank stocks are often thought of as a safe investment, particularly when the Federal Reserve is keeping interest rates stable or paring them back. There's talk on some corners of Wall Street that bank stocks are the place to be now that Fed Chairman Ben Bernanke is signaling there may be a pause in the current cycle of rate hikes.

Much of the optimism about the future for bank stocks is borne out in the Philadelphia KBW Bank Index, which is up 5% for the year, compared with the meager 1% rise in the S&P 500. In recent weeks, the bank index has risen toward the high-water mark it reached earlier this year.

The bullish case for bank stocks got some additional juice when most lenders reported reasonably good second-quarter profits, despite fears that the Fed's past rate hikes would deplete their earnings prowess. Most banks hit or beat analyst targets, and only a couple, most notably Commerce Bancorp(CBH Quote) and M&T bank(MTB Quote), cited interest rate troubles.

But the banking sector's best days may be behind it. Even if the Fed does as expected and stops raising rates, banks may have a tough time finding room to grow earnings. Industry analysts and some traders say the deteriorating housing market will create trouble for banks with large mortgage-banking businesses. And banks can't count on loan defaults -- which are running near their all-time lows -- to stay that way for much longer, now that there's evidence the overall economy is slowing down.

Indeed, many commercial banks realigned their focus over the last several years, adding to their mortgage lending businesses as they grew along with the booming real estate market. JPMorgan Chase(JPM Quote), Wells Fargo(WFC Quote) and Washington Mutual(WM Quote) benefited from the growth in their mortgage lending.

But recent indicators show that the housing market is slowing along with the rest of the economy, which isn't a good thing for lenders.