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Bank stocks: Bad year ahead?
Banks will face many challenges in 2006, but don't give up hope just yet.
By Shaheen Pasha, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) - Between bad loans, declining home sales and upside-down interest rates, 2006 is probably going to be a tough year for banks.

So if you own bank stock, should you pack it in before the ball drops on New Year's Eve? Not necessarily, say the experts. Just be careful.

Rough patches ahead

Banks are going to have a tough time, no doubt about it. Merrill Lynch analyst Edward Najarian said in a research note that he expects the median earnings per share growth for large regional banks to slow to 6 to 7 percent, down from 8 to 9 percent in 2005 due in part to net interest margin pressure stemming from a flat or inverted yield curve.

The yield curve, which refers to the slope of rates in the Treasury bond market, briefly inverted earlier this week as the yield on 10-year Treasuries temporarily fell below that of two-year notes. It's a rare event because investors tend to demand higher yields on longer-dated bonds to compensate for the risk of higher inflation later and is sometimes interpreted as a sign that the economy is headed for a recession.

The yield curve is particularly important to financial institutions because banks and securities firm borrow money at short-term rates and lend at long-term rates. A flat yield curve, therefore, squeezes margins. An inverted one hurts a bank's profits.

But Dick Bove, an analyst at Punk Ziegel & Co., said bank earnings are historically less affected by the slope of the yield curve and more directly hurt by a spike in loan losses.

"A careful analysis of bank earnings suggests that an increase in the loan loss provision at banks is the most compelling determinant of declines in bank profit," he said. "From 1950 to the present, every decline in bank earnings occurred in a year when the loan loss provision was rising."

Still, that's hardly comforting, as most analysts expect loan loss provisions to climb significantly next year. Merrill's Najarian said loan loss provisions, which declined for three years due to improving underlying credit quality, started rising modestly in the third quarter and should continue to climb next year and into 2007.

Diversified banks can breathe easier

Jeff Kleintop, chief investment strategist at PNC Advisors, added that the financial sector, which used to be dominated by lending activities, has branched out into other activities, such as merger financing and asset management.

That diversification should provide some relief from negative headwinds in 2006, analysts said.

"Banks should benefit from the constructive outlook for capital markets," said Jason Goldberg, senior research analyst at Lehman Brothers. "And banks will also experience an acceleration in credit card growth in 2006 as mortgage activity slows" due to higher interest rates.

Goldberg added that consolidation may also play a bigger role in the banking industry in 2006 as the competitive landscape heats up and banks look to expand into particularly hot markets such as Texas, California and the New York area.

And the potential winners are...

So which banks may outperform next year? Look to valuations, analysts said.

Bove was bullish on the prospect for the big, moneycenter banks such Citigroup (Research) and JPMorgan Chase (Research). He pointed out that both the two universal banks are currently trading about 10 1/2 times projected 2006 earnings while the average regional sells at about 12 1/2 times earnings.

He added that Citigroup -- which underwent a massive rebirth this past year, as Chief Executive Charles Prince sold off non-core businesses, instituted a rigid ethics model and bid farewell to top executives that had served under the former CEO Sanford Weill -- has put its regulatory issues behind itself and "is now in growth mode."

JPMorgan and Bank of America (Research) stand to benefit from merger-related synergies from their acquisitions of Bank One and FleetBoston, said Lehman's Goldberg.

As for regional banks, Merrill Lynch's Najarian -- who is largely bearish on the group next year -- said Wachovia (Research) is the firm's top pick among large regional players for 2006 because the company has a well diversified business mix, an attractive footprint in the fast-growing Southeast market and continues to gain market share while generating above average-core deposit growth.

Merrill Lynch has an investment banking relationship with the firms noted in this story and a member of Najarian's team owns shares of Bank of America.

Punk Ziegel's Bove doesn't own shares of any of the companies mentioned and the firm doesn't have banking relationships with the companies.

Lehman Brothers has an investment banking relationship with Citigroup and JPMorgan and a non-investment banking relationship with Wachovia. An analyst on Goldberg's team owns shares of Citigroup and JPMorgan.

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Is the yield curve hinting at trouble ahead? Click here to find out.

What's the outlook for M&A in 2006? Find out more on that story. Top of page

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