Banks broke out the brooms for a little housecleaning in the fourth-quarter earnings season, focusing on problem loans. But even with some of the cobwebs off the balance sheet, banks must still contend with a slowing economy that is muddying the sector's outlook.

Thursday's Coverage

Internet Companies Trudge Into the Fog

For Banks, Hitting the Loan Books

Previously

Getting a Handle on the Wireless-Handset Slowdown

Why This Earnings Season Has Been So Brutal

Earnings Burned Investors, but the Tech Fire Remains

With No Catalyst, Stocks Rumbling and Stumbling Through February

"The fourth quarter of each fiscal year tends to be somewhat of a 'cleanup' quarter for the bank group in general," said

Putnam Lovell

banks analyst Jennifer Thompson in a review of super-regional bank earnings released this week. "Many banks take the opportunity to up-front expenses, build reserves or aggressively charge off some questionable loans. This fourth quarter was no different."

Indeed, it didn't help that many banks were forced to dig into already lackluster profits in order to bulk up their loan-loss reserves (funds set aside to cover the cost of bad loans). The slowing economy quickly intensified some troubled companies' ability to repay loans extended in the easy-money days of 1997 and 1998, when a number of banks relaxed lending standards. And a decline in capital markets activity slowed banks' brokerage businesses.

But financial sector stocks shifted into rally mode near the end of last year as talk of interest-rate cuts intensified. Though the

Fed didn't announce its

first rate cut until Jan. 3, banks and brokerages started to rally at the end of last year. The

Philadelphia Stock Exchange /KBW Bank Index

has jumped about 12% since the beginning of December, while the

American Stock Exchange Broker/Dealer Index

has added 21%. And with

two rounds of rate cuts under the market's belt, investors are hungry for more, looking for signals that the Fed will drop rates further as it tries to steady the economy.

Toasted

Loans such as the one made to

Sunbeam

(SOC:NYSE), which has since filed for Chapter 11 protection,

set the tone for the quarter, casting a shadow on exposed lenders, in this case

First Union

(FTU)

and

Bank of America

(BAC) - Get Report

.

Still, despite being depressed, results generally didn't fall to the depths of Wall Street's worst expectations. Core earnings grew at an average rate of 3.8% from a year ago, notes Thompson, but "half the banks posted double-digit EPS growth this quarter. And while sequential revenue growth was less than 5% on average, eight of the 13 banks posted high single-digit growth or more."

Her universe of super-regional banks includes

Fifth Third

(FITB) - Get Report

,

Wells Fargo

(WFC) - Get Report

and

Bank One

(ONE) - Get Report

. And while asset quality "clearly deteriorated, it did not fall off a cliff," she says.

Andy Collins, banks analyst at

ING Barings

, takes a similar view. "Investment banking results were a little bit stronger than my very reduced expectations," Collins says. "Credit costs were in line and private equity was in line" with expectations. Indeed, brokers and banks with sizable brokerage businesses presented something of a mixed bag.

While a slowdown in capital markets activity was

readily apparent at brokerage

Morgan Stanley Dean Witter

(MWD)

,

Merrill Lynch

(MER)

managed to sidestep the weakness with its wide range of financial services.

J.P. Morgan Chase

(JPM) - Get Report

struggled with writedowns in its private equity arm, while

Citigroup

(C) - Get Report

managed a decent quarter thanks to strong credit card and insurance units.

Jamie's Surprise

The one company that did catch nearly everyone off guard was Bank One, which reported an

unexpected loss because of an eye-opening $1 billion it added to its provision for loan losses. "The surprise was the cleanup at Bank One. That one was way off," says Collins. Analysts had expected the Chicago-based bank to post a profit of 45 cents, but the bank headed the opposite way, reporting a 44-cent loss.

Still, thanks to its hefty provision in the latest quarter, says Thompson, Bank One was the only bank in her review that actually has a larger cushion for credit risk than the others. She sees a troubling trend in the fact that loan-loss reserves compared to nonperforming assets (loans that are past due but have not been charged off) declined at a number of banks from the third to the fourth quarter.

On a brighter note, both Collins and Thompson say they are beginning to see stabilization in net interest margins because of declining interest rates. And Collins predicts credit costs will stabilize by the third or fourth quarter.

In its 2001 banking industry outlook,

Lehman Brothers

wrote that net income growth could average between 8% to 10% for the 52 banks it covers. But there are a number of what-ifs built into that scenario: "EPS growth will require stronger operating leverage, prudent capital management and only modestly rising credit costs," the bank wrote.