Rally in Bank Stocks Doesn't Add Up

The deteriorating credit situation, sliding profits and burgeoning loan loss provisions that banks are reporting in the second quarter hasn't stopped the stocks from going up.
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Financial reports for many banks in the second quarter have looked remarkably consistent: sliding profits, mounting loan losses and soaring stocks.

Large-cap banks such as

Bank of America

(BAC) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

,

Wells Fargo

(WFC) - Get Report

, even

Citigroup

(C) - Get Report

managed to beat the meager profit expectations of Wall Street analysts, despite smaller profits and a continued deterioration in credit trends.

Approximately 56% of the 39 financial companies in the

S&P 500

that have posted results so far have beat earnings estimates, according to Thomson Reuters. Since the beginning of last week, the

Keefe Bruyette & Woods Bank Index

, which tracks the top 100 banks, is up 35%.

Even some banks that posted larger-than-expected losses, such as

Wachovia

(WB) - Get Report

, saw shares rise after it pointed out that a further public capital raise is so far unnecessary.

"The results for the most part were encouraging for the quarter," says Frank Barkocy, the director of research at Mendon Capital Advisors, which runs the Burnham Financial Services Fund. "I think there was a feeling that maybe we're moving in the right direction."

"Historically the group has tended to respond six months or more in front of the peaking of the problems," he said. "The fact that the stocks were oversold and there were some encouraging signs, have resulted in the rally."

Barkocy said that for the most part earnings were "in-line to modestly better than expectations." Even where there was a shortfall in results, a good portion of it was due to banks' continuing to build loan losses, and "in a number of instances we saw a slowing in the pace of new nonperforming assets being added," he said.

Merrill Lynch

(MER)

posted a loss of $4.7 billion, or $4.97 a share last week amid $9.4 billion in writedowns and impairment charges. Yet the New York investment bank's stock is up 22% over the past week.

Washington Mutual

(WM) - Get Report

, rocked by the housing downturn and the subprime credit crisis, posted a quarterly loss late Tuesday of $3.3 billion, or $6.58 a share. The nation's largest thrift took a $5.9 billion provision to cover charge-offs and add to its loan loss reserve. It also predicted that its cumulative mortgage losses could be roughly $19 billion.

Despite the negative news, WaMu shares had briefly rallied in after-hours trading as CEO Kerry Killinger assured investors that it had "sufficient capital."

Observers say that investors have already priced the worst of the bad news into financial stocks.

"Clearly expectations were very low going into the quarter and credit didn't deteriorate to the magnitude in terms of the pace of what investors were clearly pricing in the quarter," says Credit Suisse analyst Todd Hagerman.

Many banks were able to post earnings that were higher than expected in part due to outlooks that were overall extremely low for the group. Investors feared that, like the several preceding quarters, banks would announce large capital raises and dire situations for not only their mortgage books, but other asset classes as well. And while the results from most banks weren't good -- credit trends in mortgage, credit cards, auto and even select spots in commercial loans deteriorated -- the sky wasn't falling either.

"I think the market has painted our industry with a broad brush," BofA CEO Ken Lewis said on a conference call earlier this week. "It seems to me that there is a big difference between those banks that have diversified and those banks with concentrations or funding issues."

"Most of our businesses are performing very well, even with the state of the economy and the problems in housing. We believe our revenue streams are sustainable," Lewis said.

Expansion of the net interest margin -- the profit a bank makes for taking in deposits and lending out again -- at many banks also boosted earnings. That helped offset elevated provisioning expenses and reduced funding costs, analysts say. The banks were benefiting from the impact of the

Federal Reserve's

rate cuts earlier this year.

Hedge fund manager Tom Brown of Second Curve Capital goes so far as to say that the financial markets bottomed last week on his blog,

Bankstocks.com

, saying he "can get comfortable with their potential future credit losses and (in the cases where they are needed) the possibility of future, dilutive capital issuance."

"

Second-quarter earnings results are providing encouraging signs that the credit problems won't turn out to be as great as widely feared, that not as much dilutive capital will need to be raised, and that fewer companies will have to cut their dividends," he writes on Tuesday. "It is by no means clear sailing from here. Even so, the stocks are significantly undervalued under all but the harshest economic scenario. The evidence from second-quarter earnings to date is that that scenario won't come close to happening."

Flash Rally

Still some analysts say that the rally will be short-lived as it had more to do with short-coverings than it had to do with investors buying bank stocks because of improved fundamentals in the group.

Banks are still slogging through declining credit trends, particularly as the pain surges past hard-hit subprime mortgages into other areas like home equity and certain prime loans, such as the popular option adjustable-rate mortgage. As home prices continue to decline -- significantly in some areas -- loss estimates are also likely to be higher than initially thought. The pain could extend into 2010, crimping bank earnings for quarters, if not years, to come, many say.

"While certainly expectations were low going into second-quarter earnings, the rally and the moves seen in the stocks -- I think we're getting a bit ahead of ourselves knowing that credit will continue to get that much worse," Hagerman says. "Obviously investors are trying to grasp that sliver of hope, but as the months continue to wear on and the economy continues to weaken, reality will once again cement itself in the investor sentiment and we're likely to see a bit of a pullback."

He says the third quarter will be just as difficult as the second quarter.

"There is still a fair amount of risk attached to the group as we get into the third quarter," Hagerman says. "I won't be surprised if we learn of additional companies trying to raise capital and again pre-announcements relating to further writedowns on these loan portfolios and additional provisions."