Bank Earnings on Tap After Wild Quarter

Scroll down to listen to audio clips of Laurie Kulikowski's interview with Hardesty Capital Management's Eric Schopf for an investor's take on banks repaying bailout money and the Public Private Investment Program.

With the economy still fumbling through a deep recession and regulators and Congress pushing for greater control over the inner workings of banking institutions, the second quarter did not represent ordinary times in the financial sector.
A Busy Second Quarter for Banks

The bank stress tests conducted by the federal government, subsequent capital raises, stock conversions and accounting changes that went into effect between April and the end of June all will significantly impact bank earnings, which are set to begin rolling out with JPMorgan Chase's ( JPM) results on Thursday and Citigroup's ( C) and Bank of America's ( BAC) reports the following day.

Citi, BofA and Wells Fargo ( WFC) are among nine of the nation's 19 largest banks that have not yet repaid the federal government's preferred equity investments made through the Troubled Asset Relief Program. Others, like JPMorgan, US Bancorp ( USB) and BB&T ( BBT) have repaid the government after stress tests determined they were adequately capitalized.

Eric Schopf, vice president and portfolio manager at Hardesty Capital Management in Baltimore, offered his thoughts on what to expect in a conversation with Give an overall assessment of how you think the bank sector measured up in the second quarter.

Eric Schopf: There were an awful lot of moving parts in the second quarter. That's evident by the estimates out there on Wall Street and they're pretty much all over the place. It's fair to say that in the second quarter there are a number of trends that will carry over from the first quarter. First and foremost, unemployment continues to be a problem and that is going to weigh heavy on the consumer side of the balance sheet, if you will. Consumer loans are going to continue to underperform. Credit cards are going to continue to be a problem. Banks are going to be building the loan loss reserves. They're probably not high enough yet. And then, obviously, housing has still not corrected.

The good news is that the yield curve continues to be steep. Short-term interest rates are near zero. So for those banks that have a large deposit base, they have a very inexpensive source of capital. It will help their net interest margin.

There are some improvements in the second quarter -- primarily in the investment management area and in principal trading. So for those larger banks that have operations in those areas, I think they're going to show some real improvement there.

The balance of what happened during the quarter lends a lot of uncertainty, not necessarily to the second quarter, but going out for the balance of the year. Here we're talking about, for example, the credit card regulations. I think that these companies are dynamic enough where they'll eventually figure it out and change in order to make the best of the situation, but over the short term it's going to be a learning process for them and they're going to have to deal with that. That could result in lower profitability, maybe fewer loans outstanding. I would think that if you're not going to be able to charge as much for your money, you're just not going to make your money as available to as many people.

Another point of uncertainty will be the repurchase of the warrants associated with the TARP money. It's a process that might end up taking a little longer than anybody had anticipated ... but I think the banks want to get out from under that completely and it's going to take some negotiations on their part to get there. But again, if they're not exactly sure what they're going to have to pay, we're not sure how that's going to impact profitability, at least in the near term.

Several large banks including JPMorgan Chase and BB&T repurchased the government's preferred stakes during the second quarter. I'm sure that a lot of regional banks will be grinding to pay back their TARP stakes as well. Once that happens, what does that mean regarding forward growth at these banks.

When the banks pay back this preferred money many of them had to raise other capital to replace it. So they certainly have the wherewithal financially to prosper. But in order to get to that point we're going to need the demand for money to be there and we're going to need some of the problem loans of the past to dissipate, instead of adding to loan loss reserves every quarter. That's what we're really going to need to see for the banks to turn it around and for them to show some really good earnings growth.

AUDIO: Schopf on banks repaying TARP.

Still, the economy is not out of the woods yet. During the quarter, many banks picked up speed on home foreclosures after a temporary moratorium, Moody's said that credit card charge-offs hit above 10%, while commercial real estate credit trends also declined. How will that play out in bank earnings? Will reserving and charge-offs be as bad as prior quarters? When should we begin to see some tapering off?

They will certainly taper off at some point. Whether that's in the third quarter or the fourth quarter it's very difficult to say. ... The unemployment number was just released against the month of June and it wasn't pretty. As long as that number stays high, as long as GDP is posting a negative number, I think it's unrealistic to expect that business is going to look okay on the banking front. The only way it would improve is if the banks got way ahead of this and they were reserving way more money than perhaps what they would need to. And I don't think that they are at that point yet. So I would say the reserve build will continue for at least another quarter or two and then perhaps we can look for things to improve a little bit.

I think it's worth saying also that a lot of the big guys geographically are very widespread, whereas with the smaller banks a little more regional in nature they may or may not be impacted by what's going on other than what's in their local economy. So even though a regional bank might be at a better reserve position on paper, in fact they might not be as well positioned because the economy in their area is worse.

A big issue this year was the changes made to mark-to-market accounting rules, which many banks blamed for excessive losses seen at the height of the credit crisis. As an investor, what are your thoughts of the easing of the rules?

I think the idea of mark-to-market is a good idea. I like the transparency that it provides. I like that everyone is kind of on a level playing field. At the same time, I don't think that when the mark-to-market rules were put in place they contemplated a financial crisis of the magnitude in which we saw.

I think it's also problematic in the face of the idea of the public private investment plan. The PPIP is a good idea to maybe get some of these troubled assets off of bank balance sheets so the banks look a little healthier ... but now in a situation where they have a little more latitude in terms of how to value these assets they might not be in a position where they even have to sell them. So it kind of knocks the legs out from underneath a plan that might otherwise be beneficial.

AUDIO: Schopf on the Public Private Investment Plan.

The Financial Accounting Standards Board also changed the way off-balance sheet items will be accounted for. How will that affect earnings and, again, as an investor, does it concern you?

It doesn't concern me. I like the idea of bringing a lot of these things onto the balance sheet where you can clearly see what's going on. It makes an awful lot of sense and it should be a good thing. Where we run into problems is again if there is some sort of a blowup where the true light of the day is shown on these things and then you realize there is a problem. But the whole idea that something can be off-balance sheet just doesn't make any sense.

What financial names is the firm putting their money into these days?

Well, there is a new financial stock we have added to -- Hudson City Bank ( HCBK). And the thinking there was for the most part they were able to avoid a lot of the bad loans that were made by some of their competitors. They operate throughout the New York region. Real estate is typically expensive in its footprint. They're involved in a lot of jumbo and non-conforming loans. A lot of people have vacated that area of the market, so it puts them in a position where they can fill that void.

We still own JPMorgan. It's held up well. The problem with JPMorgan is because it didn't take a huge dive like many of its competitors, we don't expect the stock price to climb dramatically like some other bank stocks might do.

We own Bank of America stock. We think it is a very well-run bank. We like the collection of businesses that they have. Clearly they paid too much for a few of their acquisitions over the past couple of years, but once they get through this and you look at their asset base, this bank will eventually be able to earn an awful lot of money.

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