The Daily Interview: The Outlook for Bank Stocks - TheStreet

Despite an aggressive series of interest-rate cuts by the

Federal Reserve this year, including

Wednesday's 25 basis-point cut, bank stocks are up a mere 1% during the same period. Historically, Fed cuts have been ample fuel for a rally in the financial sector, as lower rates make for cheaper borrowing fees and increased liquidity in the loan market. That doesn't seem to be the case this time around, though.


Jennifer Thompson
Banks Analyst and
Vice President,
Putnam Lovell

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In part, that's because banks have branched out into businesses beyond lending, in an effort to escape interest-rate volatility. That means they're protected when rates are on the upswing, but it also provides a limited boost when rates are falling. And the easy lending standards of 1996 and 1997 are still causing headaches for many large lenders, as an economic slowdown makes it tougher for borrowers to repay the money they owe. Banks also are grappling with everything from rising credit costs due to loan deterioration, to lower revenues from the investment banking business they eagerly sought a piece of in recent years.

With second-quarter earnings season just around the quarter, we talked to

Putnam Lovell

Vice President Jennifer A. Thompson, who analyzes super regional banks, or those that operate subsidiaries in two or more states. Thompson explains why banks are having a tough time breaking out of the current weak-earnings cycle, and why she believes the weakness will continue at least into the beginning of next year.

TSC: A few months ago, there was an optimistic tone in the bank sector on the expectation that the fourth and first quarters were the low point of the earnings cycle and that things would start to pick up as the year progressed. What are your current expectations for the second-quarter earnings season?

Thompson:

I think right now banks are operating in a challenging environment. Certainly, economic and market pressures continue to be evident in second-quarter results. There are a couple of difficult quarters coming up, and I don't see a lot of potential for banks to surprise on the upside. Until you see some more visibility or better earnings, the group could continue to move sideways.

TSC: So how many more quarters of disappointing earnings can bank investors expect?

Thompson:

I definitely think as we move through the second and third quarters,

these quarters will seem less and less meaningful. The focus is going to move toward 2002. The fourth quarter is often seen as a cleanup quarter

i.e., banks getting poorly performing loans off the balance sheet. This year's fourth quarter might be even more messy than in the past.

TSC: So what will banks need to do to survive the next few quarters?

Thompson:

The ability to grow revenues is crucial in this environment. Efficiency implementations are limited by the need to invest in technology and higher-growth businesses. Stronger banks will turn to revenue growth to drive earnings-per-share growth. Credit costs are still rising, risk-adjusted reserves,

which are used to cover the cost of loan write-offs, have come down. Banks that have revenue growth will be able to overprovision to build back their reserves.

TSC: Which banks do you put in the "strong" camp then?

Thompson:

I still like

Wells Fargo

(WFC) - Get Report

and

U.S. Bancorp

(USB) - Get Report

. You have to look for companies that have a competitive advantage in their market with respect to their business or strategy and these banks do.

TSC: What are your thoughts about the ongoing consolidation in the bank sector, given Washington Mutual's (WM) - Get Report acquisition of Dime (DME) and the bidding war for control of Wachovia (WB) - Get Report?

Thompson:

I think that in slower economic times, consolidation becomes even more attractive

as a way to drive revenue growth because the pricing is lower, providing potential acquirers with even more opportunities to target. I think consolidation is going to be an attractive option for banks in higher-growth markets. The Southeast is still attractive, so is the Pacific Northwest. I think Texas could also see some consolidation.

TSC: Speaking of banks in the Southeast, what are your thoughts on the ongoing fight between First Union (FTU) and SunTrust (STI) - Get Report for Wachovia?

Thompson:

First Union has the wind at their back

because their bid is a friendly, board-approved deal. I would give them a little bit of an advantage... But I wouldn't rule out SunTrust.

Certainly, either First Union or SunTrust is going to lose Wachovia. It's going to be both a challenge and an opportunity, depending on how the winner is able to execute the deal. On the one hand, it could provide the opportunity for one bank to go in and pick up some business left on the table, or it could pose a greater challenge. I don't think we've seen the final bid yet.

TSC: Anything else bank investors should keep in mind in the coming weeks?

Thompson:

I think the challenging environment that existed in the first quarter is still prevalent in the second quarter. So far, there are not a lot of indications that things are going to improve significantly anytime soon.