Safety May Not Lie in Banks

Betting on banks is getting tricky.

Bank stocks are often thought of as a safe investment, particularly when the Federal Reserve is keeping interest rates stable or paring them back. There's talk on some corners of Wall Street that bank stocks are the place to be now that Fed Chairman Ben Bernanke is signaling there may be a pause in the current cycle of rate hikes.

Much of the optimism about the future for bank stocks is borne out in the Philadelphia KBW Bank Index, which is up 5% for the year, compared with the meager 1% rise in the S&P 500. In recent weeks, the bank index has risen toward the high-water mark it reached earlier this year.

The bullish case for bank stocks got some additional juice when most lenders reported reasonably good second-quarter profits, despite fears that the Fed's past rate hikes would deplete their earnings prowess. Most banks hit or beat analyst targets, and only a couple, most notably Commerce Bancorp ( CBH) and M&T bank ( MTB), cited interest rate troubles.

But the banking sector's best days may be behind it. Even if the Fed does as expected and stops raising rates, banks may have a tough time finding room to grow earnings. Industry analysts and some traders say the deteriorating housing market will create trouble for banks with large mortgage-banking businesses. And banks can't count on loan defaults -- which are running near their all-time lows -- to stay that way for much longer, now that there's evidence the overall economy is slowing down.

Indeed, many commercial banks realigned their focus over the last several years, adding to their mortgage lending businesses as they grew along with the booming real estate market. JPMorgan Chase ( JPM), Wells Fargo ( WFC) and Washington Mutual ( WM) benefited from the growth in their mortgage lending.

But recent indicators show that the housing market is slowing along with the rest of the economy, which isn't a good thing for lenders.

"Any of those banks with exposure to real estate, you have to be wary of," says Tim Ghriskey, chief investment officer at Solaris Asset Management. "It is a very competitive environment, and exposure to real estate is fraught with peril, so consumer lending is potentially fraught with peril."

In particular, Ghriskey says he'd avoid lenders with big exposure to the California mortgage market, where home prices have weakened the most.

In theory, any pause by the Fed in raising interest rates should be good for banks because it might lead to a widening of the gap between short- and long-term interest rates. During the time the Fed has been ratcheting up short-term rates, interest rates on the 10-year Treasury have been falling. For much of this year, the yield curve -- which measures the spread between short- and long-term bond rates -- has been flat. And in a flat-yield-curve environment, banks have difficulty finding higher-yielding investments in which to reinvest their depositors' money.

The bulls argue that once the Fed stops raising short-term interest rates, the yield curve will widen and banks will go back to printing money. There's some truth to that point of view. But analysts say it's not that simple. The Fed is not a group of magicians, and sometimes they misread the economic tea leaves.

"A lot of bank stocks will react very positively to the easing in the short term, because, under most scenarios, expectations are that the yield curve is going to steepen,'' says Allen Puwalski, senior analyst at the center for financial research and analysis. "The worst-case scenario is if six months from now the market decides the Fed overshot and you end up with a flattened yield curve."

Indeed, some worry that after the much-anticipated pause, the next move by the Fed could be to start reducing rates -- an event that could be a harbinger of economic weakness.

"The stock market environment sets the stage for the Fed to move to a hiatus sooner rather than later," says Ghriskey. "Earnings in the third quarter are likely to be fine, but there is a level of pessimism in the air."

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