In Search of Quality in Banks' Bottom Line - TheStreet

Concerns about credit costs and fourth-quarter cleanup charges prompted one analyst to issue a cautionary note on the banking sector Monday just a week before the group reports earnings.

Still, processing banks, which are considered less exposed to these pitfalls, may provide a source of refuge.

"For the industry, we believe credit risks remain significant given ongoing issues with commercial defaults, Latin America and $5 trillion of unused credit lines," said Prudential Securities analyst Mike Mayo in a research note on Monday. "Potentially higher interest rates could also hurt margins and fixed income capital markets activity."

Mayo, who has an underperform rating on the group, downgraded

Bank of America

(BAC) - Get Report

, citing losses from

Enron

(ENE)

and Latin America.

Unpegged

The crisis in Argentina has deepened in recent weeks, with the country finally devaluing its currency by 29% on Monday. That move has renewed concern about banks' exposure to the region.

Bank of America is believed to have about $900 million of loans in Latin America while

FleetBoston

(FBF)

, which was downgraded by Salomon Smith Barney Friday on similar concerns, has about $6.6 billion in loans there. In a preannouncement last month, Fleet said it took a $150 million charge on its portfolio of Argentine government securities and loans.

"Latin America is a pretty contained problem, and for most of the group it is a nonevent," said Sean Ryan, an analyst at Fulcrum Global Partners.

Still, Mayo said in a conference call that many banks have not factored in both a default and devaluation, and that most are pricing in a zero percent chance of contagion.

He added that while many pundits expect problem loans to peak in the second half of the year, the FDIC isn't expecting them to peak until the end of 2003. Even if the economy turns around, he said, lower credit costs have rarely fueled higher returns.

"Problem loans are a significant risk, albeit one that is uneven across the industry," said Ryan. "Some companies will sail through this but others are going to struggle."

Hangovers

Ryan believes the big acquirers like Bank of America,

Bank One

(ONE) - Get Report

and

Wachovia

(WB) - Get Report

face problems as they recover from "economically destructive transactions" during the downturn.

Still, banks known for processing securities trades for mutual funds and institutional investors are better positioned.

"The processing banks have less exposure to (credit) issues, a lower risk profile, relatively small impact to a likely increase in deposit insurance and the best track record among any bank subgroup in creating economic value over the past decade," said Mayo, who upgraded

Mellon

(MEL)

,

Bank of New York

(BK) - Get Report

and

PNC Financial

(PNC) - Get Report

Monday.

Mayo noted that loans at Mellon have fallen to just $10 billion from $35 billion three years ago while Bank of New York will soon write off its problem loans. Bank of New York said last month that it would take a $275 million associated charge in the fourth quarter, although it said it would meet analysts' profit estimates for the period excluding that charge and other one-time items. As for PNC Financial, it too will write off problem loans and has cut its loan exposure in half over the last three years.

State Street

(STT) - Get Report

was also upgraded Monday, although Mayo said that earnings quality "has not been so perfect given greater than average reliance on items such as securities lending and spread revenues in recent quarters."

Double-Digits

Many banks will report earnings next week. Most have already said they expect to meet 2002 estimates after taking big charges against fourth-quarter results. Bank earnings are expected to rise 22% in the fourth quarter and 25% in 2002.

"Overall I expect to see some pressure on revenues from higher credit costs and rising non-performing loans," said Claire Percarpio, analyst at Janney Montgomery Scott. "But processing banks have a lower proportion of their assets in loans and a lower proportion of their earnings is derived from lending."

In addition, she said that many of these stocks underperformed in 2001 and are due to gain back some of what they lost. Indeed, Bank of New York fell almost 25% in 2001 while Mellon lost 22%. PNC was down 20% and State Street shed 15%.

In contrast to other analysts, Anthony Polini, an analyst at Advest believes FleetBoston, Bank of America and

U.S. Bancorp

(USB) - Get Report

look attractive right now because of their low P/Es.

Fleet trades at 15 times forward earnings while Bank of America and U.S. Bancorp trade at 12 times future earnings. Bank of New York, on the other hand, trades at 20 times future earnings while Mellon trades at 22 times 2002 results and State Street has a forward multiple of 24.

"We expect the industry indices to underperform in 2002, with select banks outperforming," he said. "Our near-term bias is to play the large-cap banks with above-average cyclical leverage."