Morningstar Advisor - June/July 2010 - 63

Sector Rap

The Banking Sector Knocks on Wood
By Haywood Kelly

Banks are tiptoeing out of the recession’s shadow, but it wouldn’t take much to send them back.

The banking sector, so key to the well-being of our economy, is on the rebound. Bank stock prices are still below 2007 levels in most cases, but many have returned 100% or more over the past year. I recently checked in with members of Morningstar’s banking team —Matt Warren, Jaime Peters, James Sinegal, Erin Davis, Maclovio Pina, and Michael Kon— to see how the healing process is coming and whether we’re out of the woods.
Q: Financial stocks have rallied hard over the past year. How are the fundamentals looking? A: The mood in the sector has markedly improved from last year. Most importantly, recent data suggest that, after a long and painful climb up, new defaults on mortgages and consumer loans are finally declining. While commercial real estate remains a serious headache for many banks, the improvement in mortgages and consumer loans is likely a harbinger for a turn in the credit cycle. This means that banks with sizable consumer loan books might soon benefit from lower credit costs. Q: How did bank profits look in the first quarter? A: J.P. Morgan JPM started off this earnings

loan loss front. Bank of America BAC quickly followed suit, showing lower consumer loan losses and benefiting from strong results at Merrill Lynch. Despite the positive signs in consumer loan losses (early stage delinquencies are down in pretty much every loan category), however, J.P. Morgan’s management remained cautious about the upcoming year. We don’t blame it. The stability in the housing market could disappear if interest rates start to trend up or unemployment continues to rise. Foreclosures are actually set to increase as customers either flunk out of or fail to qualify for modification programs.
Q: What about Citigroup C? A: Credit losses remain sky-high at Citigroup, but delinquencies are trending downward, giving hope for the future. Citigroup charged off $8.4 billion of loans this quarter, an annualized run rate of 4.65% on its $722 billion of loans. However, compared with the company’s $50 billion in reserves (or 6.8% of total loans), any sign of improvement is likely to allow the company to reduce its provisions going forward, giving a nice boost to earnings later this year.

barring a double dip in the global economy. However, shares outstanding have gone from roughly 5 billion to 29 billion, leaving no doubts that this crisis and Citigroup’s poor management leading into it have permanently damaged shareholders.
Q: You also recently raised the fair value estimate for Wells Fargo WFC. A: We have come to expect a lot from Wells Fargo—the company continually outperforms its peers. First-quarter results lived up to our expectations, and favorable credit trends bode well for the balance of the year. Wells Fargo was also very upbeat in its assessment of the economy, suggesting that credit losses peaked during the fourth quarter and would continue to trend downward. Q: The team recently did a study to see which banks’ earnings were benefiting from the timing of their loan-loss provisions. Please summarize the report. A: Looking beyond management’s language, we decided to take a look at the first-quarter numbers and see which banks’ bottom lines were helped by underprovisioning for losses and which banks were punished by still building their allowance for loan losses. We found the bigger banks benefited in the first quarter, either matching charge-offs or

season with strong results in investment banking and positive news on the consumer

Overall, Citigroup turned in a decent quarter, given the current economic environment. Capital is strong. (Citi’s Tier 1 common ratio stands at a whopping 9.1%.) We expect that earnings will remain in positive territory,

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Morningstar Advisor - June/July 2010

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