Two Great Banks Just Got Downgraded to Underweight, Shares Fall

NEW YORK ( TheStreet) -- Atlantic Equities analyst Richard Staite downgraded Wells Fargo ( WFC) and US Bancorp ( USB), two of the most highly regarded stocks in the banking sector, to "underweight" on Wednesday.

Shares of Wells Fargo was down 0.6% to $40.41 in afternoon trading while US Bancorp were losing 0.4% to $35.28.

Staite sees little room for positive earnings surprises from the two banks, given expectations are already running high and valuations are rich. Both Wells Fargo and US Bancorp are highly profitable, earning returns on assets and tangible equity that are well above the industry average.

The Atlantic Equities analyst said Wells Fargo is likely "overearning" relative to its normal capacity due to high mortgage refinance volumes.

"Mortgage production revenue was abnormally strong in 2012, driven by wide margins and high refi volumes. WFC and USB were the largest beneficiaries with 14% and 9% of total revenue generated from this source, up from only 7% and 3.5% in 2011," he wrote.

Wells Fargo is already earning above its target return on assets of 1.3%. While the consensus among analysts is for returns on assets to stay above this rate, Staite believes the bank will earn less in the coming quarters.

"While all commentators expect a reduction in refi we remain concerned that the scale of the decline could still surprise," he wrote.

The analyst expects industry refininancing volumes to fall 25% in 2013 and as much as 60% in 2014.He expects Wells Fargo to see a decline in mortgage production revenue from $12.2 billion in 2012 to only $7.5 billion in 2013 and $5 billion in 2014 and 2015.

Meanwhile, U.S.B ancorp is already earning close to its normalized earnings levels on an ROA basis and should remain stable, according to the analyst. The bank is also expected to see a sharp decline in mortgage production revenue from $1.9 billion in 2012 to $1 billion by 2015.

Both banks are most exposed among peers to a slowdown in mortgage production revenue, according to the analyst.

Staite instead considers Bank of America ( BAC) a top pick. According to the analyst, the bank is currently "underearning" by as much as 50% due to high legal and asset servicing costs. He expects the gap to narrow to 10% by 2015, although consensus expects the gap to remain at 21%. -- Written by Shanthi Bharatwaj in New York.

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