With a few exceptions, the fourth quarter was kind to the nation's banks. On average, analysts are predicting bank earnings will rise about 10% over the year-ago quarter, fueled by higher consumer borrowing, a slight uptick in commercial lending and robust capital markets activity at the big money-center banks such as Citigroup ( C), J.P. Morgan Chase ( JPM) and Bank of America ( BAC). To date, there have been only a handful of earnings warnings in the banking sector. The most serious one was from Fifth Third Bancorp ( FITB), which said earnings would fall some 50 cents a share below previous estimates. The Cincinnati-based bank blamed the shortfall on charges it took to reposition its balance sheet, after rising interest rates took a big bite out of its portfolio of mortgage-backed securities. Some analysts and investors had expected other banks, not properly hedged for the rise in interest rates, to report similar balance-sheet woes. But no similar warnings ever materialized. That has led many who follow the banking sector to expect a minimum of bad news from the quarter when banks begin reporting their numbers in earnest over the next two weeks. "Earnings will likely be in line or slightly above," says Tim Ghriskey, chief investment officer of Solaris Asset Management in Bedford Hills, N.Y. But going forward, the banking sector is likely to find tougher terrain due to a combination of rising interest rates, tepid commercial borrowing and a slowdown in the mortgage market. A flattening of the yield curve -- the spread between short-term and long-term interest rates -- also will bring to an end the so-called carry trade, which had been a big source of income for many banks. In the past few years, banks have feasted on the wide divergence between rates. The historically low short-term rates enabled banks to borrow money on the cheap and reinvest in higher-yielding mortgage-backed securities.
"Going forward, we will see further compression of the net interest margin," says Michael Stead, portfolio manager for River Aire Investment. Net interest margin is a measure of the profitability of a bank's loans; banks typically generate profits by reinvesting deposits and other assets into higher-yielding investments. Michael Mayo, a Prudential Equity analyst, says he's still not expecting "robust" commercial loan growth in 2005. While this year will be better than 2004, commercial borrowing will remain well below historic levels. Mayo doesn't foresee a real rebound in corporate borrowing until 2006 at the earliest. "The industry's weak revenue growth is probably not going to improve much this year due to commercial loan growth considerations,'' says Mayo, in a recent research report. To complicate matters, most expect consumer borrowing, the one revenue source banks have been able to count on for the past three years, to begin to peter out, as consumers strain under a record amount of credit card, auto and mortgage debt. Much of the focus then will not be on the actual fourth-quarter numbers but on what bank executives say about the rest of this year. The early word from Buffalo-based M&T Bank ( MTB), one the first large banks to report fourth-quarter earnings, illustrates the mixed fortunes many are expecting from the banking sector. The bank, which reported a 15% gain in fourth quarter earnings on Tuesday, warned that 2005 revenue will rise at a slower pace than in the past year. M&T said it expects rising interest rates and slow loan growth to crimp revenue. The more challenging environment in 2005 is likely to result in muted gains for many bank stocks, which, on average, are up 34% over the past two years. Analysts at Fox-Pitt Kelton, for instance, say bank stocks are currently within about 5% of their likely peak. The investment firm, part of Swiss Re Group, favors stocks of large-cap banks over those of smaller banks, because the valuations are more favorable.
Stead similarly expects the nation's largest banks to be the top performers. Fees from investment-banking work, he says, will offset any shortfall in commercial lending and consumer borrowing at Citigroup, Bank of America and Wachovia ( WB). But Stead, formerly a money manager at Wells Capital Management, is shying away from regional lenders such as Hibernia ( HIB), Comerica ( CMA) and SunTrust ( STI) because they lack the capital market heft of their much bigger peers. He's also not a fan of banks that depend heavily on mortgage banking or have invested heavily in interest-rate-sensitive mortgage-backed securities. Some of the names on Stead's list of banks to avoid include New York Community Bank ( NYB) and Washington Mutual ( WM). In banking right now, it might pay to think big.