Updated from Wednesday, April 8

The state of the consumer is getting worse, which spells more bad news for struggling banks and other financial companies set to begin reporting earnings next week.

While some Wall Street optimists were hoping that the first quarter would start to show signs of recovery, it is clear that mounting job losses and dwindling confidence in the economy took a toll on consumers during the first three months of 2009.

The unemployment rate soared to its highest levels in 26 years, reaching 8.5% during the quarter as businesses downsized to navigate through the environment.

As more people lost their jobs, many found it harder to pay their bills and spending dropped as consumers looked to shore up their finances. Consumer borrowing, on a seasonally adjusted basis, fell 3.5% in the month of February to $2.56 trillion, according to the latest economic data available from the Federal Reserve.

Earnings at the largest consumer-oriented financial companies will reflect their customers' troubles.

Banks including Bank of America ( BAC) and JPMorgan Chase ( JPM) are expected to post sharply lower profits vs. the year-ago period.

"I definitely think things are getting worse and that's echoed in continued in unemployment and the savings rate," which is now positive, says Dean Barber of Barber Financial Group in Lenexa, Kan. "Consumer debt is as big a problem as corporate and government debt."

Barber says "the degree of uncertainty surrounding our economy is also weighing on the consumer." Companies looked to save money by tightening worker compensation, by reducing or eliminating pay raises and bonuses, and in some cases implementing salary reductions. The moves resulted in making it harder for consumers to pay down excessive debt.

"The consumer is more concerned today with themselves and the preservation of their family and their ability to feed their kids ... as opposed to consuming non-staple discretionary-type items," he says.

Of course, analyst expectations also were sharply lower for Wells Fargo ( WFC), which on Thursday pleasantly surprised investors by saying it expects a big first-quarter profit. The San Francisco company said in a preliminary earnings report that it made $3 billion, or 55 cents a share, bucking analysts' estimates of 23 cents a share for the first quarter.

But Wells, which acquired Wachovia on Dec. 31, could be an exception among the banks. The company front-loaded its writedowns on the troubled Wachovia acquisition in the fourth quarter. It also took a first-quarter provision of $4.6 billion, which included a $1.3 billion credit reserve build, the company said.

Wells Fargo CFO Howard Atkins said in an interview with CNBC on Thursday that the bank is now able to start benefiting from the Wachovia-Wells combination as it puts credit woes from Golden West's Pick-a-Pay mortgage portfolio behind it. He also said that the bank is seeing signs of life in the California housing market.

Still, " it's premature to predict we've seen the bottom or the top of the credit cycle," Atkins says.

Paul Miller, an analyst at Friedman Billings Ramsey, believes that Wells Fargo is "under-reserving for expected future losses" and that credit quality "materially deteriorated" in the first quarter.

"While the market is reacting favorably to the EPS beat and the stronger tangible common equity ratio, we remain cautious based on what we don't know," such as trends in nonperforming loan trends, net charge-offs excluding purchase accounting adjustments as well as its inherited Option ARM portfolio, he writes in a note.

Fourth-quarter delinquencies across the banking industry jumped in virtually every loan category in the fourth quarter, including credit cards, indirect and direct auto loans, marine loans and other personal loans, as job losses intensified, according to the American Bankers Association.

Home equity loans and lines of credit in particular set new records as a percentage of late accounts, the Washington, D.C.-based organization said.

Still, for the first quarter, ABA chief economist James Chessen was hopeful that "we'll start to see some inklings of improvements for institutions," he says.

"Having said that, I am certainly not rosy about what will happen in 2009," Chessen says. "... Credit losses tend to follow the economy not lead it. There is still a fair amount of pain that will be experienced for the rest of the year. We continued to see very large layoffs and that will translate into credit losses six months from now."

On the mortgage front, just over 10% total mortgages were "non-performing" in the final three months of 2008, compared to 7% at the end of September, according to a recent report by the Office of the Comptroller of the Currency in conjunction with the Office of Thrift Supervision.

Prime mortgages experienced the biggest jump in serious delinquencies (those more than 60 days late) from 1.1% in the first quarter of 2008 to 2.4% by the end of the year, the report said.

Even more troubling, so-called re-default rates on loans that had been modified in the first three quarters of last year, yet did not reduce payments by more than 10% a month, were rising, the agencies said.

"The reasons for high re-default rates are not clear. As noted in the previous quarter's report, high re-defaults could be the result of a worsening economy, excessive borrower leverage, or poor initial underwriting," the agencies said.

The report covers the mortgages serviced by BofA, JPMorgan, Citi, First Horizon ( FHN) , HSBC ( HBC), OneWest (formerly IndyMac), PNC ( PNC), US Bancorp ( USB) and Wells Fargo -- which represent approximately two-thirds of all outstanding mortgages in the U.S., given the recent acquisitions.

For the week ending April 4, there were 36,175 personal bankruptcies filed, up 24% from the week earlier and 86% from the year-earlier period, according to Fox Pitt Kelton Cochran Caronia Waller. The weekly filings so far this year have been the highest since 2006 and are approaching levels seen in 2005 and 2002, according to a note published on Wednesday.

Credit Card Pain on the Rise

Personal bankruptcies are highly correlated to credit-card charge-off rates, analysts say.

Credit card delinquencies and charge-offs have been on the rise as the financial crisis expanded past the housing crisis into a consumer-led recession. Credit card issuers such as American Express ( AXP) and Discover Financial ( DFS) as well as banks that also have large credit card businesses such as BofA, Citi, JPMorgan Chase and Capital One ( COF) are experiencing pain.

JPMorgan Chase CEO Jamie said he does not expect "2009 to be a good year for the credit card business," he wrote in a letter to shareholders last week. "In fact, we do not expect to make any money in card services this year."

Analysts expect American Express' charge-offs to peak between 10% and 12% this year, given that its credit profile is worse than that of its credit card-centric competitors. The company will also have to add a significant provision to its reserves sooner rather than later because of its bad loans, they say.

Goldman Sachs ( GS) downgraded the company to sell a month ago.

But Citi analyst Donald Fandetti has become slightly more optimistic on American Express, given that shares are down nearly 40% over the past four months as well as some signs of credit market recovery. He upgraded the New York-card services company on Tuesday to hold from sell.

"While we expect the news flow for American Express to remain negative, the case for material downside to the shares is less compelling as sentiment is already very bearish against the company and there are signs of potential credit market stabilization," he writes.

That said, Fandetti adds that the card company's operations will be "quite challenging" this year. He would not be surprised to see the company post "a few quarters of negative EPS."

But there are some bright spots that could result in positive news for the financial sector.

One area is mortgage refinancing. Due to the record-low interest rates combined with the government's efforts to incentivize home ownership, banks are seeing a refinance boom this year.

BofA C EO BofA's Ken Lewis said on CNBC last week that the company is receiving unprecedented volume for refinance applications, which will "put a lot of money in consumers' pockets."

He also said there have been modest signs of improvement on delinquency rates for consumer debt like credit cards over the past two months.

E*Trade Financial ( ETFC) also noted an improvement in early delinquencies on a month-to-month basis in its troubled home equity portfolio.

Still, analysts say it is too early to call an improvement in credit quality.

" We caution against reading too much into such a development, as one data point does not make a trend," Wunderlich Securities analyst Kevin Reynolds writes in a note. "Credit quality will remain the major issue for the next several quarters, but deterioration (or improvement) is unlikely to evolve in a linear fashion."

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