Banks' outlook depends on credit risks

Now that fears of a global financial meltdown have faded, many on Wall Street have returned to one of their favorite pastimes: cheerleading bank stocks.

In jargon reminiscent of the creative "pro forma" accounting (in which extraordinary expenses were made to vanish) era of the late 1990s, analysts are now commonly referring to "normalized earnings" in their bank research reports. By "normalized," they mean profits stripped of all those messy loan losses and multibillion-dollar, reserve-building charges that brought bank stocks to their knees a year ago.

Last year's horror show seems forgotten. The Standard & Poor's 500 financial index, which measures the stock performance of the nation's largest publicly traded banks, has surged 150 percent since the market bottomed on March 9.

Yet, is the worst really over for the banking sector? And is it a good idea to look past those loan portfolios and focus on the seemingly bright recovery ahead?

Barometers of banking's health

Investors looking for answers to those questions should watch what happens this Wednesday when Wells Fargo and U.S. Bancorp -- the nation's fourth- and sixth-largest banks, respectively -- release their third-quarter earnings. As more traditional banks, they are considered better barometers of the health of the banking sector -- and the Main Street economy -- than financial behemoths Bank of America, Citigroup and J.P. Morgan Chase, which released earnings last week.

A number of serious credit risks remain for both banks, any one of which could derail their recent rally, said several industry analysts. Wells Fargo's stock has nearly quadrupled since March 9, when it hit its lowest price in about 13 years. U.S. Bancorp has tripled since early March, when it traded at $8.06, its low of more than 14 years. "Maybe we shouldn't be looking at the 'normal' numbers," said Jaime Peters, a bank analyst at Morningstar. "Maybe the normal numbers are telling lies. There are so many reasons to be cautious right now."

To Peters, the big unanswered question is whether these banks have put aside enough cash to absorb whatever grim economic news the economy throws their way.

Even though both banks built their loan-loss reserves considerably over the past year, taking multibillion-dollar hits to their earnings, they still have lagged most of their big-bank peers, according to an analysis by SNL Research of Charlottesville, Va.

Wells Fargo and U.S. Bancorp rank 20th and 24th, respectively, among the nation's largest banks in the amount of reserves they have set aside as a percentage of their assets, according to SNL Research. As of the second quarter, Wells Fargo had set aside $2.65 in reserves for every $100 in loans -- compared with $4.19 at J.P. Morgan and $3.37 at Bank of America. U.S. Bancorp has reserved $2.31 for every $100 in loans.

That has Jon Fisher, a portfolio manager at Fifth Third Asset Management in Minneapolis, which oversees $19 billion in assets, concerned. "There are two sides to the coin," he said. "Either they've got their credit issues under control, and they don't see significant deterioration in credit quality if they look out the next six to 12 months, or they're wrong and they're being way too optimistic and they'll have to play catch-up."

Some analysts argue that Wells Fargo may be more vulnerable to a surprise increase in bad loans because a much higher percentage of its loans are tied to consumers -- about 40 percent -- than at many other large banks.

Loans to consumers continue to go bad at an accelerating rate, as rising unemployment and weak housing prices push more people into distress. Just last week, Wells Fargo cited weak consumer credit quality as one reason it decided to hike interest rates 3 percentage points on most of its 5.9 million credit card customers.

Wells Fargo's loan portfolio is also loaded heavily with commercial real estate, which tends to behave poorly toward the end of a credit cycle, said Fisher of Fifth Third. Losses on commercial real estate typically lag the rest of the economy, because they often occur after a business has shut down or an office building has emptied of tenants. Last week, leaders of three federal bank regulatory agencies warned that commercial real estate lending currently poses the biggest threat to the health of U.S. banks.

Wells Fargo's loan charge-offs on its $340 billion commercial and commercial real estate portfolio ballooned to $1.2 billion in the second quarter ended June 30, up from $380 million a year earlier. "What if commercial real estate fell off a cliff?" Peters said. "Those are the kinds of questions that keep you awake at night."

U.S. Bancorp's loan portfolio is simpler and less prone to surprises, say analysts. The Minneapolis-based bank has met or exceeded earnings expectations in 60 percent of the past 20 quarters -- one of the highest rates among major banks in the nation, according to a recent report by Sandler O'Neill & Partners. Even so, the bank's second-quarter charge-offs on bad loans more than doubled over the same period a year earlier -- and they have yet to show signs of abating.

"In general, there appears to be some healing in the banking world," said Jennifer Thompson, a senior analyst at Portales Partners in New York. "But, of course, if you're going to be worried about something, it's going to be credit quality."

Chris Serres • 612-673-4308