10 Big Banks Stocks to Watch In the 'Kitchen Sink' Quarter (Update 3)

Updated with market close information, the downgrade of Bank of America by Credit Suisse, Oppenheimer's upgrade for KeyCorp and downgrade of Comerica, and PNC's announcement on Wednesday morning of several fourth-quarter items.

NEW YORK ( TheStreet) -- Fourth-quarter earnings reports will be quite messy for many of the nation's largest banks.

2012 was a remarkable year for bank stocks, with the KBW Bank Index ( I:BKX) returning 30%, after falling by 25% during 2011. Bank of America ( BAC) led the way among the 24 index components, with shares rising 110%, following a 58% drop in 2011.

After a bumpy right toward year-end as the fiscal cliff negotiations dragged on in Washington, bank stocks have been strong so far during 2013, as positive economic reports continue to roll in. Investors, however, can expect plenty of first-quarter volatility for the entire market, including the banks, as the arguments rage in Congress over raising the federal debt limit.

Guggenheim Securities analyst Marty Mosby said in a report on Wednesday that during the fourth quarter of 2011, "14 of our 18 Large Cap Banks reported results below market expectations. We expect year-end cleanup decisions to pull down fourth quarter results again." The analyst see some good news for the industry: "Beyond this noise, modest revenue growth, continued efficiency improvements, and deployment of excess capital are creating core earnings growth."

A Lumpy Fourth Quarter Banks Clearing Mortgage Decks

Bank of America has led the way for banks reporting extraordinary fourth-quarter items, announcing on Monday a settlement of its long-running feud with government-sponsored mortgage giant Fannie Mae ( FNMA) that will include a cash payment of $3.55 billion and a $6.75 billion payment to repurchase 30,000 loans sold to Fannie before 2008. With some of the costs associated with the settlement having already been reserved for, Bank of America said that the entire Fannie Mae settlement would lower its fourth-quarter earnings by $2.7 billion.

In addition to the Fannie settlement, Bank of America also announced that its fourth-quarter results would be "negatively impacted by approximately $2.5 billion (pretax) for the independent foreclosure reviews, litigation (primarily mortgage-related), and other mortgage-related matters," leaving the company to report "modestly positive" earnings. The company said that its estimated range for additional mortgage putback losses had declined to a maximum of $4 billion as of Dec. 30, from $6 billion at the end of the third quarter.

Following on the theme of clearing out mortgage risk, Bank of America also announced Monday that Fannie Mae, Freddie Mac and Ginnie Mae had agreed to allow the company to sell the servicing rights on 2 million residential mortgage loans, with unpaid balances totaling $306 billion. About 232,000 of the loans with servicing to be transferred were past due 60 days or more. Nationstar Mortgage Holdings ( NSM) announced it would purchase from Bank of America the servicing rights for 1.3 million mortgage loans with unpaid balances totaling $215 billion, for $1.3 billion, while Walter Investment Management ( WAC) said it would buy servicing rights on 650,000 loans with unpaid balances totaling $93 billion from Bank of America for $519 million.

Bank of America is the largest participant in the $8.5 billion foreclosure settlement between the nation's largest mortgage loan servicers, the Federal Reserve and the Office of the Comptroller of the Currency, which was also announced Monday. Wells Fargo ( WFC) announced that its ""portion of the cash settlement will be $766 million, which is based on the proportionate share of Wells Fargo-serviced loans in the overall IFR population." The company also said it would "record a pre-tax charge of approximately $644 million in the fourth quarter of 2012 to fully reserve for its cash payment portion of the settlement and additional remediation-related costs." The effect of the charge will be a reduction in fourth-quarter earnings of roughly 12 cents a share, according to Stifel Nicolaus analyst Christopher Mutascio.

Credit Suisse analyst Moshe Orenbuch on Wednesday downgraded Bank of America to a neutral rating from an "Outperform" rating, saying the stock's "current valuation appears to be ahead of the company's near to intermediate-term performance and appears to be discounting significantly faster improvements in efficiency than we would be expecting." Despite the downgrade, the analyst raised his price target for the shares by a dollar to $12.00.

Bank of America's shares were down 5% on Wednesday to close at $11.43. The shares rose 110% during 2012, after dropping 58% during 2011.

Citigroup announced that it would "record a pre-tax charge of approximately $305 million in the fourth quarter of 2012 for its cash payment portion of the settlement," while U.S Bancorp ( USB) said that its "share of the settlement will include a cash payment of $80 million (pretax), which is expected to reduce fourth-quarter 2012 earnings per share by approximately 3 cents. In addition, the settlement includes a commitment to provide approximately $128 million of other mortgage assistance, such as loan modifications, which is covered by existing loan loss reserves."

Mosby on Wednesday raised his price target for Citigroup's shares to $55, implying 30% upside from Tuesday's closing price of $42.46, saying "While we do not expect C to report its full earnings power in 4Q12, we believe that its valuation is based more on reduction of loss potential in Citi Holdings and approval to deploy excess capital in March. Thus, we have increased C's price target to ~95% of year-end 2013's tangible book value." Citi's shares now trade at 0.8 times its reported Sept. 30 tangible book value of $52.70.

Could the Margin Squeeze Be Ending?

A major theme for most large U.S. banks over the past few years has been the pressure on net interest margins (NIM), as the Federal Reserve has kept its short-term federal funds rate in a target range of zero to 0.25% since the end of 2008, while also doing everything it can to push long-term rates down and hold them at their current levels.

The Federal Reserve Open Market Committee on Dec. 12 said that it would continue its purchases of mortgage-backed securities at a pace of $40 billion a month, while also "initially" continuing to buy $45 billion in long-term U.S. Treasury securities each month, in a continued effort to hold long-term rates down. The Fed also stopped its concurrent monthly sales of short-term securities, meaning that the central bank's balance sheet, at least initially, is growing faster in 2013 than it did during 2012.

The Fed's latest actions may not have the desired effect. JPMorgan Chase analyst Vivek Juneja said in a report on Tuesday that "10 year Treasury yields are up sharply by 32bp from early December lows to 1.90%. If this is sustained and followed by equal rise in 30yr MBS yields (up 21bp to date), it could modestly reduce net interest margin (NIM) pressure with lower reinvestment risk." Of course, higher interest rates would also have the effect of slowing down the mortgage refinance wave and lowering banks' income from mortgage originations and sales.

Juneja said that "overall, we expect a weak 4Q for large cap banks as pressure on net interest revenues and weak trading should be partly offset by continued strength in mortgage origination revenues and investment banking fees plus improved credit quality with continued sharp decline in loan loss reserves." The analyst said that there was "a sharp pick-up" in commercial and industrial (C&I) lending by banks late during the fourth quarter, "which would not help 4Q12 much but bodes well for 2013."

So for the fourth quarter investors can expect many of the banks to trumpet their improved loan growth, while bottom-line results will continue to be padded by the release of loan loss reserves, and a continued decline in net interest margins is offset by strong mortgage results.

Earnings Previews

Leaving out the "big four" U.S. bank and the trust banks, here are earnings previews for the ten largest KBW Bank Index components by asset size. The names are ranked by descending ratio of price to 2013 consensus earnings estimates:

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