10 Big Bank Stocks Gearing Up for Third-Quarter Earnings (Update 3)

QE3 and Margin Contraction

With the target federal funds short-term rate in a range of zero to 0.25% since late 2008, most banks have already seen all of the benefit they are likely to see from a reduction in funding costs, while long-term rates have continued to be pressured, as the Federal Reserve has continued and increased its purchase of long-term mortgage-backed securities.

The Federal Deposit Insurance Corp. reported that for the nation's nearly 7,000 banks and savings and loan associations, the aggregate net interest margin -- the spread between the average yield on loans and investments and the average cost for deposits and borrowings -- narrowed to 3.46% during the second quarter, from 3.52% the previous quarter, and 3.61% a year earlier.

Guggenheim Securities analyst Marty Mosby said last month following the Fed's latest stimulus announcement that among the largest U.S. banks, Wells Fargo (WFC) "has the most margin compression today expected over the next year," as the company has a large percentage of assets with original maturities of greater than three years, that are "repricing down now, lower than they were three years ago."

Wells Fargo CFO Tim Sloan said at a conference on Sept. 11 that the company's third-quarter net interest margin decline "could be similar to what we experienced in the third quarter of last year when our net interest margin was down 17 basis points."

During the second quarter, Wells Fargo's net interest margin, or NIM, was a relatively high 3.91%, unchanged from the first quarter, but declining from 4.01% in the second quarter of 2011. Mosby expects the company's margin to contract by a further 21 basis points from the second quarter, through the fourth quarter of 2013.

Wells Fargo posted good second-quarter results, as strong mortgage loan demand fed earnings applicable to common stock of $4.4 billion, or 82 cents a share, increasing from $4.0 billion, or 75 cents a share, the previous quarter, and $3.7 billion, or 70 cents a share, a year earlier. The company trades at a premium to the remaining three members of the "big four" banking club, reflecting stronger earnings track record over the past few years, as well as the company' increasingly strong mortgage lending position. For the 12-month period ended June 30, Wells Fargo's operating return on average assets (ROA) was 1.30%, according to Thomson Reuters Bank Insight, while its return on average equity (ROE) was 11.57%.

Wells Fargo's shares closed at $34.76 Friday, returning 28% year-to-date, following a 10% decline last year. The shares trade for twice their tangible book value, and for 9.5 times the consensus 2013 EPS estimate of $366. Mosby rates Wells Fargo a "Buy," with a $43 price target, "due to our continued expectation that WFC can produce consistent double-digit earnings per share growth."

Deutsche Bank analyst Matt O'Connor on Tuesday downgraded Wells Fargo to "Hold" from a "Buy" rating, saying the bank "is best positioned for mortgage activity remaining stronger than expected given its market share of about one-third" and increasing gain spreads on mortgage sales, but "both of these are well known and we believe already reflected in the stock."

Some banks that have already felt the worst effects of the decline in long-term rates on the asset side are set to buck the net interest margin trend, or at least see minimal contraction over coming quarters, including KeyCorp (KEY) and Regions Financial (RF).

Earnings Previews

Leaving aside our beloved big four and the trust banks, here are earnings previews for the ten KBW Bank Index components trading lowest to consensus 2013 earnings estimates. The group is sorted by descending forward P/E ratio:

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