Bank Warnings Cast Cloud on '08

Mortgage and credit woes have banks about to report fourth-quarter earnings pessimistic.
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The holidays may be over, but 'tis still the season for bank profit warnings.

Wall Street firms haven't been the only companies derailed by the credit crunch in the back half of 2007. The last weeks of the year were marked by early warnings from a handful of regional banks that profit and earnings for the fourth quarter are unlikely to bring belated holiday cheer.

The fourth quarter is typically a "noisy" quarter for bank earnings, analysts say, as companies take charges for one-time items to spiff up their balance sheets for the coming year. This particular fourth quarter, however, is shaping up to be one of the worst in years at the regional banks, which are reeling from the ongoing credit crunch and deterioration in the housing industry.

"The preannouncements are coming because the numbers are coming in significantly below consensus estimates," says Peter Winter, an analyst at BMO Capital Markets. "We're not talking a few pennies here -- you're talking in certain cases an 80% hit to estimates for the fourth quarter."

At least 16 banks of all sizes, including

Wells Fargo

(WFC) - Get Report


Washington Mutual

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(PNC) - Get Report


Fifth Third

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(STI) - Get Report



(KEY) - Get Report

, have already said that earnings would come in short of expectations.

Analysts expect the banking sector to post a 43% year-over-year drop in fourth-quarter net income, according to Thomson Financial. Regional banks are expected to post a 50% drop in net income, Thomson says. The growth rates compare estimated net income, which excludes one-time items, in the fourth quarter to actual net income (excluding one-time items) in the fourth quarter of 2006.

Banks have enjoyed years of benign credit markets that boosted earnings despite a tough yield-curve environment. But as the year marched on, banks were squeezed hard. Home prices fell, and the mortgage industry ended its high-flying cycle. Higher delinquencies on home loans mean lenders must set aside more money to cover possible defaults.

The deterioration in mortgages isn't the only problem. A general credit malaise also put pressure on banks with exposure to the capital markets, as securities backed by mortgages and other assets seized up.

Banks blamed at least one of the following: the need to build loan-loss reserves; mortgage-related losses; writedowns on various asset-backed securities, collateralized debt obligations and other capital markets issues; and several special items, such as the

settlement of litigation brought by

American Express

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against Visa and a host of member banks for allegedly conspiring to keep American Express out of the bank-issued credit card business.

"We're at the early stages of this credit cycle and banks are under-reserved ... that's been predominantly where it's been focused," Winter says. "It just reconfirms that banks were under-reserving and they're building the reserves."

California, Midwest Hit Hard

Banks with exposure to the regions with the most deterioration, notably California and the Midwest, have been hit particularly hard.

Cleveland-based Key warned that it would post a fourth-quarter loss of up to 5 cents a share, due to deteriorating credit quality in loans made to homebuilders and other writedowns in its fixed-income business.

Fifth Third said earnings would range between 24 cents and 27 cents a share. The Cincinnati bank's lower earnings stem in part from a planned $275 million provision for credit losses -- nearly double what it set aside in the third quarter. Charged-off loans are expected to be $170 million in the quarter.

Wells Fargo set aside $1.4 billion in the quarter for its most troubling loans. It also created a special fund to cover losses expected in about $12 billion in home-equity loans either purchased or originated through indirect channels, such as wholesale mortgage lending platforms and the correspondent channel.

The San Francisco-based bank expects about $1 billion in losses in the liquidating portfolio over 2008 and 2009.

To be sure, not all banks that warned of earnings shortfalls had dire news, despite the credit crunch.

U.S. Bancorp

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, for example, said it would recognize a "valuation loss" of $110 million, or 4 cents a share, from the purchase of certain asset-backed commercial paper holdings from money market funds managed by its subsidiary, FAF Advisors.

The Minneapolis-based bank said the money market funds "experienced stress arising from the liquidity disruptions and credit deterioration during the third and fourth quarter." It also recorded a charge of $215 million, or 9 cents a share, for its share of the Visa litigation.

"Banks are trying to communicate to investors that 'We're cognizant of what is going on, we're trying in many cases to get ahead of the curve,'" says Frank Barkocy, the director of research at Mendon Capital Advisors. "Not to suggest that they're at the point where the worst is behind them, but ... suggesting that 'We're trying to get ahead of these problems as best we can, based on the information we know today.'"

But the writing for a difficult 2008 is already on the wall. Banks such as WaMu are boosting the extra cash they set aside for loan losses far beyond what is expected to be charged off in the fourth quarter -- meaning losses are expected to get worse.

In conjunction with its plans to shore up capital and restructure the home lending business, WaMu is also ramping up reserves for loan losses to cushion against greater delinquencies on subprime mortgages and home-equity loans. It expects to set aside up to $1.6 billion in the fourth quarter for bad loans -- approximately twice the level of expected fourth-quarter net charge-offs.

"The banking industry is going through a period of adjustment from delivering record profits from 2004 to 2006, driven by incredibly strong credit metrics, to today

where profits have been impacted by deterioration in credit," says Gerard Cassidy, an analyst at Royal Bank of Canada's RBC Capital Markets. "We're going to see further deterioration in 2008 and the fourth quarter 'clearing the decks' that we expect is not going to be sufficient for the potential problems that we see in 2008."

Analysts also say the poor banking environment is likely to hold back the number of deals made in the sector next year.

Goldman Sachs analyst Lori Appelbaum writes in a recent industry note that M&A is likely to be limited next year, given the lack of potential buyers -- whether from integrating other deals, like

Bank of America's

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purchase of LaSalle Bank, capital constraints, or further concerns about credit deterioration.

The one exception could be Wells Fargo, which "intends to be opportunistic in a period of uncertainty," she writes.