What banks say about the economy

(Money Magazine) -- As the economy goes, so goes the financial sector, which explains why bank shares have taken a hit ever since fears of another slowdown emerged. But you can't just look at stock prices. You have to weigh the performance of the underlying businesses. When you do, you may be in for a bit of a surprise.

With unemployment about as high as it's been in 30 years and the nastiest real estate bust in almost a century still playing out, you'd think that big banks would be having a rough time making money, right?

Actually, they're pretty much printing profits. The big four -- Wells Fargo (WFC, Fortune 500), Bank of America (BAC, Fortune 500), Citi-group (C, Fortune 500), and J.P. Morgan Chase (JPM, Fortune 500) -- collectively earned almost $14 billion in the second quarter.

The good news: Fewer deadbeat borrowers

This is a reflection that banks are having to charge off less to cover bad loans, which suggests the worst of the credit mess is really behind us. Wells recently trimmed its loan-loss reserves by $500 million, which went straight to its bottom line. Over the next few years, it could release as much as $11 billion more.

Another plus for banks: Funding costs are incredibly low right now. While you may be frustrated with the paltry interest rates you're getting on your CDs, these low rates are manna from heaven for banks.

The bad news: Fewer people want to borrow

Of course, banks need to make loans to thrive -- and this is where a problem emerges. The fact is, households aren't just paying off their debts, they're borrowing less in general. Bank of America reported that while it added new credit card accounts in the first half of 2010, the overall balances outstanding for its card portfolio declined 15% vs. 2009.

This is what the economists mean when they talk about deleveraging. Being less indebted is great for consumers and for the long-term health of the economy, but it's painful in the short run as income is diverted from consumption to debt reduction.

Advantage: Wells

Lower loan demand will probably be a speed bump for bank stocks. But this doesn't mean you should avoid them altogether. Just focus on banks that enjoy the tailwind of better credit quality without the head-wind of declining loan activity.

That sounds like a pretty attractive investment thesis to me, and it's exactly what Wells Fargo is about.

Wells has always been a master of cross-selling -- existing customers take advantage of six of the company's financial products on average -- and the bank has been applying its well-honed sales practices to the new customers it acquired when it bought Wachovia in late 2008. This pool of untapped demand should be a great source of revenue growth for Wells even as overall demand for credit across the economy shrinks.

The analysts here at Morningstar think Wells will be able to wring a lot of value from the Wachovia acquisition, and we think the stock is worth $41 a share. That's about 70% more than the current price of $24.

-- Pat Dorsey is the director of equity research for Morningstar.