With the nation's banks set to start reporting first-quarter earnings this week, some worry that the profit numbers may not be enough to justify investors' recent enthusiasm for financial stocks.
Philadelphia KBW Bank Index
is up 11% since mid-March, amid optimism on Wall Street that a quick end to the war in Iraq could mark the start of an economic revival and better days for the nation's lenders.
Yet there are signs that bank lending operations may now be getting crimped by low interest rates -- which led to a surge in home mortgage refinancings and helped banks navigate the recession. Some fear that banks might start reporting a decline in net interest income -- the difference between the interest rate banks charge on loans and their own borrowing costs.
For many banks, net interest income is one of the main revenue drivers, especially for regional banks, which were some of the top-performing financial stocks last year. A decline in that important revenue segment could overshadow an expected improvement in the percentage of overdue and nonperforming commercial loans in bank portfolios.
Just last week, Tennessee-based
National Commerce Financial
warned it would miss first-quarter earnings estimates because of a shortfall of $5 million to $6 million in its lending operation, as a high number of borrowers opted for much cheaper floating-rate loans rather than fixed-rated ones. The warning has knocked 17% off National Commerce's stock price, and some say it could be a sign of things to come.
"Our biggest risk is that we underestimated the impact of net interest margin compression," said Michael Stead, a Wells Capital Management portfolio manager. "It's a distinct possibility the quarter may look worse than we anticipated."
Stead, who manages Wells' SIFE financial services fund, said he's lightening his position in a number of bank stocks in advance of their earnings releases. Stead declined to identify the stocks he was selling, but said the most vulnerable may be banks that offer customer-friendly free checking accounts. That's because those lenders don't have other fees to offset the decline in interest income.
Some of the bigger banks that offer free checking with small minimum deposit requirements are
. A few of these banks even pay interest on free checking accounts.
Another risk for banks in the current low interest rate environment is a potential decline in value of their own investment portfolios, which are used to generate income and also offset the costs of their lending operations.
Of particular concern is the fact that a growing number of banks are putting more of their investment money into mortgage-backed securities. With interest rates so low, many mortgage-backed securities are being prepaid early and reinvested at lower rates -- and that means a smaller return for banks.
Michael Mayo, a Prudential Securities bank analyst, said this is a big concern for many banks, because mortgage-backed securities now account for roughly half of the banking industry's $1.3 trillion investment in securities. In a recent research report, he cautions investors to be on the lookout for "unexpected large margin declines" at banks that invest heavily in mortgage-backed securities.
Some of the bigger banks with large mortgage-backed securities portfolios include
, Fifth Third and
One reason some investors favor Puerto Rico's
right now is that it invests heavily in Ginnie Mae mortgage-backed securities -- government-sponsored investment vehicles that enable banks to loan money to low- and moderate-income homebuyers. Analysts see this more conservative approach as reducing Doral's risk in the event of defaults or early prepayments, and they like the fact that the interest on Ginnie Mae securities is tax-exempt.
As for quarterly earnings,
J.P. Morgan Chase
Bank of America
are expected to benefit from a surge in bond trading, something that helped boost first-quarter earnings at
. Analysts expect the gains in trading revenue to more than offset an expected decline in investment banking dollars at the nation's three biggest banks.