3 Bank Stocks to Buy Ahead of Earnings From Deutsche

NEW YORK ( TheStreet) --Large-cap banks will likely display checkered results in the third quarter, with strong mortgage origination and decent trading activity boosting revenues, while lower interest rates, tightening credit spreads and slowing pace of credit quality improvements could dampen the bottomline.

In a report published Monday, Deutsche Bank analyst Matt O'Connor highlighted some of the key themes for the third quarter.

One significant item for universal and investment banks such as Bank of America ( BAC), JPMorgan Chase ( JPM) and Goldman Sachs ( GS) would be an accounting loss stemming from a tightening of credit spreads on U.S. bank bonds.

An accounting quirk called a debit-valuation adjustment allows banks to book a profit when the value of their bonds fall as technically it means they can buy back their debt at a lower rate. When market confidence improves and the value of bonds rise, banks, conversely, book a loss.

Regulators are considering removing this controversial accounting provision according to press reports, but for now, the results are likely to swayed by this rule.

Net interest margin pressure is likely to be another dominant theme, according to the report. While banks may not be readily passing on lower rates to borrowers- at least, not as much as the Fed would like- they still face a significant reinvestment risk in a low yield environment. Banks with heavy investments in mortgage-backed securities also face the risk that borrowers will prepay their loans.

On the positive side, the analyst notes the modest loan growth, decent trading activity on a year-on-year basis, and continuing credit improvement.

He expects fewer mortgage putback surprises. This report was published before federal regulators filed a lawsuit against JPMorgan, alleging that its Bear Stearns unit defrauded investors in the sale of residential mortgage-backed securities.

New York Attorney General Eric Schneiderman has warned that more cases could be filed against other big banks, so the threat of further lawsuits still looms over the banks.

Here is a look at three big bank stocks that are well positioned for third quarter, according to Deutsche Bank's O' Connor.

3. Fifth Third Bancorp FITB Total Return Price Chart FITB Total Return Price data by YCharts

Shares of Fifth Third Bancorp ( FITB) are up 23% in 2012 but it still trades at a 10% discount to peers on 2013 earnings, according to O'Connor.

This is despite the fact that the bank has consistently above average return on equity, above-average capital with its Basel 3 Tier One ratio at 9% versus 8% for peers, a higher dividend yield of 2.6% and a higher-quality earnings stream , the analyst notes.

The Fed recently approved a 25% increase to its dividend after denying it earlier this year. It also received permission to buy back $ 600 million in stock, which was more than what analysts were expecting.

The potential upside to 2013 earnings from the recently approved share buybacks has not been fully reflected in consensus, according to O'Connor. A stronger second half from better-than-expected mortgage performance could also serve as a catalyst.

The analyst expects the bank to report an earnings per share of 38 cents in the third quarter in line with consensus.

Fifth Third reports on Oct.18.

Goldman Sachs GS Total Return Price Chart GS Total Return Price data by YCharts

Goldman Sachs ( GS) appears to be once again the darling of bank analysts, with the stock getting several bullish recommendations in recent weeks.

Shares of the investment bank heavyweight are up 30% year-to-date.

"A few solid quarters in a row seem likely and could help GS shares re-rate higher", writes O'Connor.

Goldman's third quarter topline should get a lift from higher fixed income trading revenues and a rebound in the performance of its investment and lending division thanks to higher market levels.

Meanwhile in the fourth quarter, the bank is likely to benefit from compensation expense reversals, while the first quarter of 2013 will be seasonally strong..

O'Connor expects Goldman to report an earnings per share of $2.70 excuding a DVA hit of 60 cents. Including DVA, EPS is expected to be $2.10 versus $2.08 consensus.

Goldman reports October 16.

PNC Financial Services PNC Total Return Price Chart PNC Total Return Price data by YCharts

Upgrading the stock to a buy from hold, O'Connor argues that PNC Financial ( PNC) is in the process of addressing most of the issues dogging the bank.

Shares of PNC have underperformed in 2012 as earnings have been clouded by one-time items following its acquisition of the US. Operations of RBC Capital.

The bank has however given more clarity about its "purchase accounting accretion" recently. The analyst also expects greater clarity on how the bank expects to achieve its Basel 3 target of 8 % to 8.5% in the third quarter.

Also additional "one-timers" in the upcoming quarters have been well-telegraphed and results are likely to be cleaner in 2013, according to the analyst.

Deutsche expects PNC Financial to report an earnings per share of $1.61 excluding RBC merger charges versus a consensus estimate of $1.60.

PNC is set to report on Oct 16.

-- Written by Shanthi Bharatwaj in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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