The Federal Reserve did the nation's banks no favor last week with its surprise half-point interest rate cut.

The cut, which dropped overnight lending rates to 1.25%, has sparked a losing streak for bank stocks, with the Philadelphia KBW Bank Index down nearly 5% since Wednesday. Shares of J.P. Morgan Chase ( JPM - Get Report) and Wells Fargo ( WFC) led the retreat.

Some of the selling was inevitable, especially since the bank index had risen nearly 21% since the first week in October. But the surprise move is not only reviving fears that the economy is weaker than previously thought, it's also causing investors to worry about an earnings squeeze.

Net Bad

"At this point, rate cuts are more negative than positive for banks," said Harold Schroeder, a portfolio manager with Carlson Capital, a hedge fund that holds both short and long position in financial stocks.

Normally, when the Fed cuts interest rates, it's a boon for banks, because it reduces their own borrowing costs and enables them to pay out less money in interest payments to depositors.

This time around, however, many banks find themselves caught in an unusual Catch-22. That's because they risk alienating their customers if they respond to the Fed's latest cut by reducing the already low interest rates they pay on checking, savings and money-market accounts.

"We've kind of reached the floor on the deposit side," said Michael Stead, a portfolio manager with Wells Capital Management's SIFE financial services fund. "If the banks go any lower, they run the risk of losing market share."

Meanwhile, in order to remain competitive, banks have no choice but to reduce the interest rates they charge to customers who borrow money. And that's something that could put a pinch into the interest income banks generate, even if the Fed cuts help spur more consumer borrowing and mortgage refinancings.

All in all, it's a recipe for what industry people call "net interest income margin compression" -- a situation in which a bank's profit margin from its lending and deposit operations shrinks.

Near-Term Grim

And that's why some bank analysts already are beginning to warn investors not to expect net interest income to serve as a catalyst for earnings growth, at least until interest rates start rising again.

"We forecast that net interest income growth will not be much of a driver of earnings for the banks next year," wrote Goldman Sachs bank analyst Lori Appelbaum, in a research note last week.

In light of that, Appelbaum advised Goldman clients that she was reducing her earnings estimates for the dozen banks she covers by an average of 1% next year, with Wells Fargo feeling a bit more pressure than other banks. She said banks that will excel next year are the ones that do the best job at generating fees from managing money, whittling down the bad loans on their books and cutting operating costs.

Overall, Appelbaum remains neutral on the near-term outlook for the banking sector.

Old Issues

Of course, the threat of margin compression at the nation's banks couldn't come at a worse time, since many big institutions are still coping with a rising tide of bad commercial loans to ailing telecommunications and energy companies.

With banks like J.P. Morgan, FleetBoston ( FBF) and Bank of New York ( BK) still taking charges against earnings for bad lending, the Fed's latest cut is sort of like rubbing salt in a wound.

If investors feel the need to jump into bank stocks now, the safer bets are probably smaller regional and community banks, which aren't weighed down with a mountain of bad telecom and energy loans.

These smaller players tend to do a better job than their bigger competitors in gathering deposits from small businesses and consumers, and they can better manage a squeeze in net margin interest income. And they are in a position to capitalize on any surge in home refinancings in light of the latest rate cut.

Some names that get bandied about include Keycorp ( KEY - Get Report), Charter One ( CF - Get Report), Sovereign Bank ( SOV), Washington Mutual ( WM) and Commerce Bancorp of N.J. ( CBH).

But overall, the rule of thumb is caution in the banking sector after the Fed's latest move.

"The reaction of bank stocks to go down was the right one," said Stead, whose $680 million fund invests heavily in bank stocks. "It does nothing for the banks. And it shows the economy is a lot weaker than we all thought."


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