Banks brace for tough second half

Some analysts and portfolio managers are bettting that the second half of 2008 will be equally painful as the first two quarters for the financial services sector.

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NEW YORK (CNNMoney.com) -- By most measures, the first half of 2008 was downright dreadful for most banks and securities firms.

It was a period marked by billions of dollars of writedowns, dividend cuts and management shakeups at some of the nation's largest financial services firms.

Shares of commercial banks plunged. So far this year, the KBW Bank Index is down 33%.

And to top it all off, there was the dramatic near-collapse of Bear Stearns in March, which only stoked investor nervousness about the sector.

A number of analysts and portfolio managers, however, are girding for more pain in the second half of 2008. Some fear it could be just as bad, if not worse, than the first two quarters.

"The stock market is clearly telling us that is going to be the case," said Bill Fitzpatrick, an equity analyst at Optique Capital Management, which oversees about $1.5 billion in assets and owns stocks such as Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500).

Whether it involved extending adjustable rate mortgages to risky borrowers or buying complex mortgage-backed securities, banks and brokerages got burned by making bad bets on the U.S. housing market.

And as real estate values continue to decline, newly constructed homes sit empty and more homeowners go into foreclosure, that only means additional trouble for the financial services sector in the months ahead.

Worried about further erosion in the economy, commercial banks have also been working to fortify their balance sheets against further losses in their consumer-related loan portfolios.

Many banks may beef up their reserves, or set more money aside to protect against delinquencies or defaults in their home equity and credit card portfolios, once again when they start reporting second-quarter results the second week of July.

According to Thomson Reuters, financial services firms in the S&P 500 are expected to report a 60% decline in net income in the second quarter from a year ago. For the full year, profits are expected to be 18% lower than last year.

If the economy worsens from here, banks may have to build those reserves even further later this year.

"Layer on top of a normal credit cycle the effect of a protracted economic slowdown and the residential real estate debacle and you have yourself a pretty difficult banking environment for the second half of the year," notes Gerard Cassidy, managing director of bank equity research at RBC Capital Markets.

The prognosis for Wall Street investment banks is not much more promising.

The number of companies that went public during the first half of 2008 was down 69% from a year ago, while the number of announced U.S. mergers fell 30% to $694.2 billion from a year ago, according to preliminary figures from deal tracker Dealogic.

If those numbers hold up for the remainder of the year, it could spell trouble for investment banks. Analysts are already betting that both Lehman Brothers (LEH, Fortune 500) and UBS AG (UBS) will post losses for the current fiscal year. Even the seemingly invulnerable Goldman Sachs (GS, Fortune 500) is expected to see its annual earnings fall by 31% from a year ago.

To make matters worse, more investment banks are cutting staff to control expenses. They are also relying less on deals and investments involving debt. Those risky bets helped deliver eye-popping returns in recent years.

And with Wall Street firms facing the threat of greater regulatory oversight after the Federal Reserve decided to temporarily open its discount lending window to them, it is understandable why the industry is in the midst of a crisis of confidence.

What might serve as a "shock absorber" in the months ahead, notes Achim Schwetlick, a partner and managing director at the Boston Consulting Group, is continued strength in investment banks' wealth management and asset management businesses.

But even if banks and brokerages do an effective job of insulating themselves against further woes, analysts agree that many firms will need to raise even more capital before year's end to keep themselves well positioned and to satisfy banking regulators.

To date, major financial institutions worldwide have raised roughly $213 billion, according to UBS.

Banks may sell more common stock to raise capital or cut their dividends further to preserve cash. Some may even sell off non-core businesses, said Ted Parrish, co-manager of the Henssler Equity fund, which owns shares of both Bank of America and Goldman Sachs (GS, Fortune 500).

"I think we are going to see a lot of the majors shed off businesses they can get some quick capital for and won't destroy their business models," said Parrish. "I think that is a certainty."

If the second half of 2008 is anything like the first two quarters, more heads could roll at top financial services firms.

Earlier this year, Wachovia's (WB, Fortune 500) board of directors booted CEO Ken Thompson from his corner office, following the company's sluggish performance. In June, Lehman replaced two of its top executives including chief financial officer Erin Callan. Washington Mutual (WM, Fortune 500) CEO Kerry Killinger was stripped of his chairman's post.

RBC's Cassidy said that pressure for more executive changes could come from frustrated shareholders or even from potential new investors.

"The quid pro quo would be 'We'll give you the money, but we have to see meaningful changes in senior management,' " he said.

Change could also mean consolidation within the industry, notes Optique Capital's Fitzpatrick.

While few companies, other than JPMorgan Chase (JPM, Fortune 500), seem positioned to go shopping, the limited growth rates for banks in this environment and the threat of potential changes to the corporate tax rate in the wake of the upcoming presidential election may prompt some banks to gobble up another.

"I think there are plenty of reasons to say over the next few months we will see some deals," said Fitzpatrick.