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TheStreet Open House

The Cheapest Bank Stocks Based on 'Normalized' Earnings: KBW

Stocks in this article: BACJPMKEYMBI

NEW YORK ( TheStreet) -- For truly long-term investors, Bank of America (BAC) and JPMorgan Chase (JPM) are the best bargains among big banks, according to KBW analyst Christopher Mutascio.

For several years, analysts and investors have been considering large banks' potential "normalized earnings" as a tool in making long-term stock picks. The credit crisis, of course, caused a few years of outsized loan losses to hammer industry earnings. In the aftermath of the crisis, the release of loan loss reserves has boosted results, but that activity can't go on forever.

The industry is also being held back by slow loan demand in many important categories. And the volume of mortgage loan applications is slowing from last year's record pace, as fewer borrowers refinance and rising long-term rates lower affordability for some potential homebuyers.

Margin Squeeze

Another major factor holding back the normalization of bank earnings is record-low short-term interest rates. The Federal Reserve has kept the short-term federal funds rate in a range of zero to 0.25% since late 2008, and the Federal Open Market Committee has repeatedly said that this "highly accommodative" policy would be appropriate at least until the U.S. unemployment rate fell below 6.5%. June's unemployment rate was 7.6% and the Bureau of Labor Statistics will announce the rate for July on Friday.

Barring an unexpected rise in inflation, the federal funds rate could easily stay in this range for another year. Banks have lowered their funding costs over the past few years, but that hasn't been enough to keep their net interest margins from being squeezed.

Long-term rates have been rising over the past several months, in anticipation of a curtailment of the Federal Reserve's monthly purchases of $85 billion in long-term securities, which has been meant to hold long-term rates down. The market yield on 10-Year U.S. Treasury bonds rose to 2.63% on Tuesday from 1.70% at the end of April.

But second-quarter net interest margins for most large banks continued to decline. What the banks need for margin expansion is a parallel rise in rates, which can only happen when the federal funds rate is increased.

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