Broad Bank Selloff Obscures Some Firms' Rate-Hike Resistance

Fear that a more aggressive Fed will hurt banks' profits prompted a selloff across the financial-services sector Thursday. But that fear is blind, according to bank-stock analysts and investors who contend that some financial institutions are well protected against further tightening.

Economic data released Thursday morning indicated that inflation is building in the economy, prompting many observers to conclude that the Fed is likely to get tougher with its interest-rate policy.

A trigger-happy central bank is usually bad news for bank stocks. When rates are pushed up, banks' borrowing costs generally rise faster than the interest rates on the money they lend. This squeezes profit margins and reduces customer demand for loans. Plus, if higher rates slow the economy, borrowers begin to default, forcing banks into earnings-eroding charges against profits.

With these fears in mind, investors sold bank stocks Thursday: The KBW Banks Index slid 3.3%. Sizzling economic data such as those released Thursday endanger the 20% rally the index has posted since its March 10 low.

Three Feet High and Rising

The Fed has already raised rates five times since they bottomed in 1998. Its interest-rate-setting arm meets on May 16. Most economists had expected it to boost the fed funds rate by a quarter of a percentage point then, perhaps followed by another increase of the same size in the summer. Now, the Fed could hike by half a percentage point in May and even continue hiking beyond the summer, economists fear.

Even so, the rush from financial stocks as a group is unwarranted, since an angry Fed is much more of a threat to some institutions than others, analysts and investors say. "Banks vary. You can't write them off across the board," says Carl Dorf, manager of the (PBTAX)Pilgrim Bank & Thrift fund. "This selloff is an overreaction. The market's psychotic."

Risk-Averse? Bank stocks analysts favor as rates rise
Company	Symbol	Recent price; trailing P/E
UnionBanCal	UB:NYSE	27 15/16; 9.9
Wachovia	WB:NYSE	63 5/8; 14.1
Mercantile Bankshares	MRBK:Nasdaq	29 3/8; 13
Golden West	GDW:NYSE	34 1/16; 12.1
Bank of New York	BK:NYSE	41 1/4; 19.3
State Street	STT:NYSE	98 7/16; 25.2
Northern Trust	NTRS:Nasdaq	63 11/16; 36.4

UnionBanCal (UB), down 3.5% Thursday afternoon, is one bank that has managed to maintain a good profit margin on its lending business through the Fed hikes, says Dorf, whose fund owns shares in the San Francisco-based bank. Its so-called net interest margin was a fat 5.2% in the first quarter, which is much wider than in the preceding quarter (4.96%) and the year-earlier period (4.83%).

Wachovia (WB) and Mercantile Bankshares (MRBK), down 4.5% and 3.1%, respectively, Thursday afternoon, both offer a mix of assets and liabilities that will help protect profitability, says Chris Marinac, a banks analyst at Robinson-Humphrey in Atlanta. (He has an outperform rating on both banks, and his firm has done underwriting for neither.) "If interest rates go up, these banks' net interest incomes could actually rise," Marinac remarks.

Thrift Is a Virtue

Thrifts are generally perceived as being more vulnerable to Fed tightening than other types of financial institutions. But even in this sector, there are possible exceptions -- like Golden West (GDW) of Oakland, Calif., says Andrew Dinnhaupt, manager of the (PREAX)PaineWebber Financial Services fund. Golden West, off 1.1% Thursday afternoon, does a lot of variable-rate lending. That means it has more opportunity to boost revenue when rates go up, explains Dinnhaupt, whose fund has no position in the thrift.

Dinnhaupt also says that banks that have massively reduced dependence on lending are better bets in this environment. Such institutions have headed into businesses that earn fees, rather than interest income, and thus are less sensitive to the direction of rates. Bank of New York (BK), State Street (STT) and Northern Trust (NTRS) are such firms. They were down 5.2%, 2.1% and 3.9%, respectively, Thursday afternoon. (PaineWebber Financial is long Bank of New York but has no position in the other two.)

Robinson-Humphrey's Marinac, however, says these fee-focused banks have high valuations that make them vulnerable in selloffs like this.

High and Tight

Of course, there are banks that may be worse off the more the Fed tightens. Marinac points to AmSouth (ASO), whose margins have come under pressure partly because it's borrowing more at a higher rate. Its stock was down 0.8% Thursday. (Robinson-Humphrey rates AmSouth neutral and hasn't done underwrting for AmSouth). An AmSouth spokesman replies: "We are no more vulnerable than other banks to changes in interest rates. We have a balanced rate-sensitivity position."

Dinnhaupt is wary of National City (NCC) and Comerica (CMA) because of recent margin pressures. The stocks fell 1.8% and 4.8%, respectively, Thursday afternoon. National City declined to comment.

Comerica's finance chief, Ralph Babb, responds: "Our strategy has been to balance interest rate risk. We have been quite successful." He points out that Comerica's net interest margin was 4.47% in the first quarter, only slightly below the 4.51% in the year-earlier period. He adds that 80% of Comerica's loans adjust with rates.

While there are winners and losers at the moment, the number of winners will be whittled down quickly if the Fed has to get really tough and enacts a lot more rate increases after the May meeting. Says Marinac: "Most banks can handle" a half a percentage point hike in May, but another quarter-point increase "could hit margins."

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