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Don't Bank on a Bottom

As first-quarter earnings season for banks and brokerages like Credit Suisse come to a close, investors increasingly seem to be calling poor results a bottom. Not so fast, some analysts say.

Credit Suisse

(CS) - Get Report

on Thursday swung to a big first-quarter loss, wrote down more than $5 billion in assets and still investors rejoiced, sending shares up more than 5% on the

New York Stock Exchange

.

The surge in the Swiss banking outfit's stock price reflects a trend over the past week set by other financials like

Merrill Lynch

(MER)

and

Citigroup

(C) - Get Report

, which also rallied on bad news, as some investors made bets that the sector had hit a bottom -- a view advanced just Thursday by Deutsche Bank analyst Mike Mayo.

"The industry is approaching the later stages of the credit crises that started last summer, given $300 billion of writedowns at global financial firms," Mayo wrote in an industry note. "While the exit may be delayed by greater uncertainty around monoline insurers, the ultimate disposition of CDOs, or continued disruption in short-term money markets, the end seems closer."

But others say the sector has a long way to go before a bottom hits.

"We'd love to tell you that the systemic storm is passed and that valuations for financials are stabilizing, but the fundamental data just does not support such a view," according to Institutional Risk Analytics market commentary published this week. "By way of a time frame reference, we're just barely into the third inning of the credit crisis ballgame."

First-quarter earnings for most banks, many of which reported over the past two weeks, were dismal, paving the way for some to say that the second quarter is likely to be just as bad. Banks and investors will continue to shift their attention from securities-related writedowns to an anticipated spike in charged-off loans, or debts the banks do not expect to be paid back. If that happens, it will eat into the large reserves banks have been setting aside in anticipation of rising defaults in a variety of consumer categories, not to mention the beginning whispers of trouble in commercial lending portfolios.

"Most of the financials are accurately priced and there is no point in wading in there right now, because I think second quarter will be at least as ugly as

the first quarter," says Christopher Whalen, managing director of Institutional Risk Analytics. "I think you could see banks consuming so much capital that some of them are going to go down a lot more."

Keefe, Bruyette & Woods, a midsize investment banking firm specializing in financial services companies, says of the 73 banks covered by KBW's research team, 48, or 66%, missed consensus earnings estimates for the first quarter. Operating earnings, which typically excludes special charges, had a median decline of 13%. Large-cap banks performed the worst, KBW says, with a 31% median profit drop.

Following first-quarter earnings, KBW cut earnings estimates for 62% of the banks under its coverage list.

In addition, credit metrics -- particularly at the largest banks -- "continue to indicate that asset quality is deteriorating at an accelerating pace," yet there has only been a "modest increase" in reserve ratios, writes KBW analyst Melissa Roberts in a note Thursday.

Deutsche Bank's Mayo echoed the sentiment. "The unique feature of this downturn is that the reserve-to-loan ratio was at a two-decade low even before considering the extra strain of going into a recession," he writes. And while banks are somewhat increasing that ratio, "loan loss reserves are still well below where they need to be," he adds.

Bargain Hunting

Some say a few of the more troubled banks present a buying opportunity, while others believe investors have already priced any forthcoming bad news into these stocks.

Washington Mutual

(WM) - Get Report

,

Wachovia

(WB) - Get Report

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and

National City

(NCC)

all were able to arrange $7 billion infusions through private equity investments, stock offerings or both, after reporting first-quarter losses.

Thomas Ruggie, president of Ruggie Wealth Management in Tevares, Fla., says his firm began investing in bank stocks such as

BB&T

(BBT) - Get Report

and

Colonial Bancgroup

(CNB)

, roughly a month ago.

"You have to put your blinders on for two years, you don't know if you're at a low or the low ... You're buying these at a significant discount and regardless of what does pop up, I believe a lot of the concern is already built in," Ruggie says. "I don't think we're through it, but a lot of it is already priced in." Ruggie's firm has approximately $300 million in assets under management through its clients.

The Institutional Risk Analytics note, however, aims to "throw the bucket of ice cold water on the growing crowd of sell side touts encouraging clients to go long U.S. financials."

"...

Key sectors of the economy which determine U.S. bank asset quality and revenue -- real estate, home building, consumer spending and credit -- are continuing to sink into the mud," it notes.

Analyst sentiment is definitely mixed about how much credit-, housing-related pain is to come for banks. Seven out of 17 analysts that cover Citi have rated the company at buy. Meanwhile, six out of 19 analysts have buy ratings on Merrill Lynch, according to

Bloomberg

.

David Ritter, an analyst at Argus Research, who rates Merrill a buy, says the firm's shares are undervalued.

"While Merrill has significant remaining exposure to problem assets, a sum-of-parts analyst indicates that

Merrill shares are currently undervalued," he wrote in a note Monday. "While we expect the

Merrill shares to be more volatile than usual over the next several months, we believe that the risk-reward balance is quite favorable."

Still Ritter cut his 12-month target stock price by $10 to $60 in the note. Shares closed up 7.1% to $48.09 on Thursday, but the stock is down by half from a year earlier.

"We believe that

Merrill shares have been oversold in the wake of the company's recent asset writedowns, which were larger than expected," Ritter adds. "Given the current state of the mortgage markets, we believe that further writedowns are likely. ... However, we believe that this negative news is already discounted in the share price."

Spotting a Bottom

Of course, the question on everyone's mind is, if bank stocks haven't yet hit bottom, when will they? While the exact time frame cannot be pinpointed, observers say it's all in the tracking of problem loans and to look for a slowing in the rate of growth for nonperforming assets.

Bank stocks typically bottom when net charge-offs are peaking -- which is after non-performing assets peak, says Mark Fitzgibbon, the director of research at Sandler O'Neill & Partners, which also specializes in banks and brokerages.

And he is not alone in having an opinion on the subject.

Unfortunately, "we're nowhere near it yet," Fitzgibbon says.