Dexia Makes U.S. Bank Stocks Look Good

NEW YORK ( TheStreet) -- The breakup of Dexia shows that there's even more uncertainty for European bank stocks than there is for most of the large, revenue-challenged U.S. banks.

The market seemed primed for a decent Columbus Day, as investors cheered the announcement by German Chancellor Angela Merkel and French President Nicolas Sarkozy that they would present a "comprehensive package" to solve the euro zone sovereign debt crisis, while propping up European banks. But the package is three weeks away, and Dexia agreed Monday to be broken up, with its Belgian banking business nationalized and the holding company left with a bond portfolio in run-off.

It sure sounds like it's 2008 across the water with surprise bank failure and bailout announcements over the weekend. Many remain uncertain which banks will acutally survive into the New Year.

For U.S. bank investors, however, there is at least some idea of how bad things can get.

Investors have already slammed the largest U.S. banks, with the KBW Bank Index ( I:BKX) sliding 32% through Friday's market close, while Bank of America ( BAC) was down 56% year-to-date to $5.90, and Citigroup ( C) was down 48% to $26.02.

U.S. banks are facing revenue challenges in every facet of the banking business, as loan demand remains weak for most of the large players, who are also seeking to make up the revenue losses from the Federal Reserve's new rules limiting the interchange fees charged by banks to retailers to process debit card purchases.

It's too early to say how consumer behavior will change in the face of monthly fees for checking accounts that were formerly fee. Of course, for the time-being, deposit flight is not a problem for the large banks, since weak loan demand means there's no shortage of liquidity.

Banks area also facing narrowing net interest margins -- the "spread" between a bank's average yield on loans and investments and its average cost for deposits and wholesale borrowings -- as the Federal Reserve's "Operation Twist" has already pushed long-term rates lower, with short-term rates staying close to zero.

Another challenge faced by banks -- following a bruising battle with regulators -- is the Volker Rule -- part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law by President Obama in July of last year -- which aims to eliminate most banks' proprietary trading operations, although key definitions still need to be ironed out. Based on federal regulators' draft proposal leaked last week, the banks will be putting in place elaborate and expensive compliance programs to comply with the new rules.

The largest banks are still facing additional fallout from the foreclosure mess, as negotiations for a settlement continue, between the largest mortgage loan servicers, federal regulators and states' attorneys general. Following $14 billion in provisions for mortgage putbacks, litigation and other expenses in the second quarter, Bank of America can be expected to take at least a one-quarter breather from shockingly large mortgage expense provisions, but there's no way to gauge the company's ultimate risk from the mortgage crisis and whether it will need to raise additional capital.

For the third-quarter earnings season, the biggest topic will be the great reductions in investment banking income, with JPMorgan Chase ( JPM) estimating in mid-September that its third-quarter markets revenue would decline 30% from the second quarter.

FBR Capital Markets analyst Paul Miller estimates that JPMorgan's total investment banking revenue will total $674 million, or a 49% decline from the second quarter, while Bank of America will see a 51% decline in investment banking revenue to $538 million. The analyst expects Goldman Sachs ( GS) to see a 36% quarter-over-quarter decline in investment banking income to $701 million, with Morgan Stanley ( MS) seeing a 35% decline to $695 million and Wells Fargo ( WFC) showing a 41% decline in investment banking income to $131 million.

The good news, according to Miller, is that his firm's risk-adjusted valuation model "indicates banks are undervalued by 40%, even after taking into account our already reduced estimates." But Miller also said in a report published Monday that "there has been no good news that investors can grab hold of to justify buying the banks and financials in general."

While recommending that most "investors stay on the sidelines," Miller said that "if they need to own financials," investors should look toward "larger banks due to cheaper valuations, better efficiency, and access to cheaper capital, which should make earnings relatively more resilient," including Wells Fargo, PNC Financial ( PNC) and U.S. Bancorp ( USB).

Miller also said there were "company-specific opportunities among the regional banks," including Webster Financial ( WBS), Susquehanna Bancshares ( SUSQ), and Fifth Third Bancorp ( FITB), which all feature a "a solid capital base, strong reserves, and a favorable outlook for loan growth.

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.