A funny thing happened to financial stocks in 2004: The Federal Reserve boosted interest rates, but stocks didn't plummet. In fact, the financial sector had a pretty good year even as the Fed raised its target for short-term interest rates from 1% to 2.25%.

There's a lesson for investors here: The spread between the interest rates banks pay for capital and the interest rates they charge to lend capital matters more than the absolute level or direction of interest rates.

That explains the gains financial stocks posted and convinces me that Bank of America ( BAC), U.S. Bancorp ( USB), Main Street Banks ( MSBK), Capital One Financial ( COF) and MBNA ( KRB) will deliver above-market returns for 2005.

I'll return to the future of those five stocks in a moment, but first let's take a closer look at how some big financials did last year.

Pockets of Outperformance

At first glance, the year was solid but not spectacular for investor favorites in the sector. Citigroup ( C) was up 3%, Washington Mutual ( WM) rose 10% and Bank of America gained 18%.

But there were pockets of huge outperformance: Credit card companies Capital One Financial and MBNA returned 44% and 37%, respectively; regional banks Main Street Banks and Commerce Bancorp ( CBH) returned 34% and 24%, respectively; and perhaps most surprisingly, some thrifts that depend on mortgage lending soared, including Golden West Financial ( GDW), which returned 44% for the year.

These returns weren't evenly distributed over the year, however. If you break down the performance for Citigroup, for example, you'll see the stock climbing to a high on April 1, then sinking to a low on Oct. 22 before climbing again. Washington Mutual shows a roughly similar pattern with a high on March 1, a low for the year on Aug. 12, and a retest of that low on Oct. 20. From the high to the October low, Citigroup lost 17% and Washington Mutual dropped 15%. But from the October low to the Dec. 31 close, the stocks gained 14% and 13%, respectively.

The charts of the big gainers for 2004 that I mentioned above show a similar pattern but with an earlier low for the year -- May 10 for BofA, Golden West Financial and Main Street Banks -- and a longer and stronger run to the end of the year. Stocks like these simply never looked back.

That pattern is pretty easy to understand -- with the benefit of hindsight, of course. The drop to the lows of March, April or May was a result of anticipation that the Fed was about to raise interest rates, as the central bank did on June 30 when it took its target short-term interest rate up to 1.25% from 1%.

The months of stagnation that followed for Citigroup and Washington Mutual were the result of worries that the Fed would raise rates more quickly than it ultimately did. And the gains from May or October came as investors realized that Alan Greenspan & Co. were indeed serious when they said that rate increases would be measured. The consensus came to realize that financial stocks didn't face the kind of interest-rate spike that has devastated the sector in the past.

A Not-Too-Shabby Spread

Rapidly rising interest rates can cause serious trouble for banks. The biggest problem occurs when the value of a bank's interest-rate-sensitive assets -- mortgages and bonds -- drops. Second, profits can quickly disappear when the difference between the short-term interest rates banks pay for money and the long-term interest rates banks charge to lend money, known as the spread, contracts.

But, remarkably in 2004, with the Fed raising short-term rates to 2.25% from 1%, neither problem surfaced. The yield on a long-term 10-year Treasury note was about 4.25% at the beginning of 2004, and it finished the year at 4.25%. The long-term assets in bank portfolios didn't plunge in value overnight.

And while interest-rate spreads narrowed, they didn't collapse. The average historical gap between short-term interest rates and the yield on the 10-year Treasury is about 1.1 percentage points. Before the Fed began to raise rates, the gap had climbed to more than 3 percentage points. Borrowing money at short-term rates, as banks do in the commercial-paper market, and then lending long (or buying Treasury notes) produced easy profits. No one expected that to last forever, of course, and the fear among investors was that the smooth ride would come to a screeching halt. Instead, the spread remained far wider than the historical average. At the moment, the spread remains a very comfortable 2 percentage points. It's not as profitable as a 3-percentage-point spread, certainly, but none too shabby, either.

Even that kind of relatively benign interest-rate environment wasn't without its challenges, and not every company was equally well positioned to meet those challenges.

A number of banks and thrifts -- Washington Mutual, for example -- had developed a business model that was so leveraged to interest rates that it couldn't escape the year without some damage. An aggressive acquisitions strategy had turned Washington Mutual into a mortgage-lending machine that was heavily dependent on generating a very high volume of new mortgages. It took only a very slight cooling off in mortgage originations and refinancings to force Washington Mutual to sell some of its home-lending centers to American Home Mortgage ( AHM) in an effort to cut expenses.

The company missed Wall Street's earnings estimates when it reported second-quarter earnings, as net income from its home-mortgage business went to zero from $611 million in the second quarter of 2003. That startling decline came about because in 2003, Washington Mutual had been able to make a profit by selling packages of mortgages that it had originated for a higher price, thanks to falling interest rates. With rates moving up, those gains disappeared.

What It Took to Win in 2004

Bank and thrift stocks that performed the best in 2004 shared similar traits: In general, they were more conservatively run, they watched expenses, they weeded out credit risks, they built sizable consumer deposits that provided a cheaper source of capital and high-fee income, and they ran flexible consumer credit card businesses that allowed them to increase rates ahead of any interest-rate hike from the Fed.

For example, Bank of America leapt ahead of the competition in the race to become the first truly national consumer-banking franchise when it bought FleetBoston. With banks and ATMs in 21 states, the company became a deposit-gathering machine. On the cost front, the bank aimed to generate $250 million in cost savings in 2004, and a total of $1.5 billion by the end of 2005.

U.S. Bancorp has turned into a specialist in generating fee-based business from its customers as it has rapidly expanded into lines such as asset management (through the 2002 acquisition of the corporate trust business of State Street ( STT)). About 40% of revenue comes from fee-based businesses.

Capital One Financial trimmed its credit card loan delinquencies, which in turn reduced the amount of money it set aside for loan losses. That unencumbered cash eventually showed up as increased earnings. That improvement in credit quality has come even as the company has continued to build its share of the market for Visa and MasterCard credit cards.

MBNA was able to improve an already strong credit quality. And, of course, as is the case with Capital One as well, credit card companies are easily able to keep the rates they charge to card holders well ahead of any increases in short-term interest rates.

And finally Main Street Banks, a stock that I added to Jubak's Picks on Sept. 10, is a prime example of a local bank that has built a consumer deposit and business-lending franchise in a targeted geographic market. That specialization gives the bank access to the best of the trends I've mentioned here: consumer deposits, high fee-based income, an ability to keep a close eye on costs and a loyal customer loan base with high credit quality.

U.S. Bancorp Stands Out for 2005

This year isn't going to be a complete replay of 2004, of course. For instance, some regions of the country, New York and Texas to take two examples, engaged in a virtual orgy of branch-bank openings in 2004. We're likely to see a contraction first in profitability at those branches, and then in the number of bricks-and-mortar branches themselves.

Commerce Bank is a master at opening profitable branches, but I'm going to give the shares a pass in 2005 until some of their less-adept competitors go through their branch shakeout. Thrifts like Golden West Financial and Doral Financial ( DRL) are just too expensive for me right now, even though I think Golden West is the best in the adjustable-rate mortgage business. The odds are that some competitor, probably in the sub-prime sector that specializes in mortgages for customers with less-than-ideal credit ratings, will blow up in 2005. That's when I'd like to buy Golden West.

With this column, though, I am going to add U.S. Bancorp to my Jubak's Picks portfolio. I think this bank is well-positioned to be a winner again in 2005. And in this stock market, I certainly don't mind that the shares pay a 4% dividend, either.

Changes to Jubak's Picks

Buy U.S. Bancorp. I'm adding U.S. Bancorp to Jubak's Picks for what it is and for what it isn't. On the "is" side of the ledger, this bank has become a specialist in generating fee-based business. As I mentioned earlier, about 40% of revenue comes from that source. That business has been growing nicely, accounting for much of the 9% earnings growth year to year, although that growth has been obscured by losses on the bank's investment portfolio and problems in its commercial loan portfolio. Now that those losses and problems seem to be behind the bank -- nonperforming commercial loans were down 50% in June from the level in June 2003 -- I think earnings growth will kick up above 10% for 2005. Investors can also count on a 4% dividend and the likelihood of future dividend increases like the 25% hike that company's board voted in December 2004.

On the "isn't" side of the ledger, the bank doesn't have much exposure to the risks of the home mortgage business: About 10% of the company's non-interest income comes from mortgages. And with the spinoff of investment house Piper Jaffray in 2003 and the acquisition of the corporate trust business of State Street in December 2002, U.S. Bancorp also lowered its business risk. As of Jan. 18, I'm adding shares of U.S. Bancorp to Jubak's Picks with a December 2005 target price of $36.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Main Street Banks and Penn Virginia. He does not own short positions in any stock mentioned in this column. Email Jubak at jjmail@microsoft.com.