Bad bank earnings: Prepare for the flood

NEW YORK (CNNMoney.com) -- Sometimes when it rains, it pours on Wall Street. And this week forecasters are calling for a flood.

Starting Tuesday, Wall Street will most likely find itself drowning in a torrent of dreary earnings news from some of the nation's biggest banks, marking yet another grim milestone for the troubled financial sector.

"It's not going to be a pretty sight," said Frank Barkocy, director of research at the investment advisory firm Mendon Capital Advisors in New York, which owns shares of a number of large banks including Bank of America and Washington Mutual.

Of the five banks and brokers scheduled to report results this week, three are expected to post a fourth-quarter loss - Merrill Lynch (MER, Fortune 500), Citigroup (C, Fortune 500) and Washington Mutual (WM, Fortune 500). JPMorgan Chase (JPM, Fortune 500) and Wells Fargo (WFC, Fortune 500) are expected to report a decline in quarterly earnings.

Since the summer, the nation's biggest banks have found themselves hamstrung by a host of problems, including tough conditions in the credit markets and ongoing weakness in the housing sector.

The worst of the news is expected from Citigroup and Merrill. The two companies, which have both hired new CEOs and acquired capital infusions from foreign state-run investment funds in the past two months, are expected to take billions in writedowns, according to Wall Street estimates.

On Friday, The New York Times reported that Merrill would take a $15 billion writedown. Recent reports have estimated that Citi could writedown as much as $24 billion during the quarter.

The two firms could also address intense speculation recently that they have been looking overseas to raise capital. Citigroup, however, which is trying to secure $2 billion in capital from China Development Bank has reportedly faced opposition from Chinese government officials, The Wall Street Journal reported Monday.

Some experts anticipate that the newly installed chief executives at Citi and Merrill may look to take bigger markdowns on their toxic mortgage securities now in order to avoid even more charges throughout 2008.

"What investors hate is quarter after quarter of writeoffs," said David Easthope, senior analyst at independent research and consulting firm Celent LLC.

Other banks have taken a preemptive approach, giving advance warning of dismal results. Last month, Washington Mutual, the nation's largest thrift, said it would report a loss in the fourth quarter, while also announcing it would slash its dividend and lay off more than 3,000 workers in an effort to shore up its capital.

Bank of America (BAC, Fortune 500), which is scheduled to report its results during the week of Jan. 21, also gave Wall Street plenty of warning that its results would not be good.

Speaking at a Goldman Sachs conference in New York last month, Bank of America CEO Kenneth Lewis said the lender's quarterly earnings would be "disappointing," adding that he expected the company to take more than the originally estimated $3 billion in writedowns.

Bank of America may also have more to say about the deal struck Friday to acquire troubled mortgage lender Countrywide Financial for $4 billion in an all-stock transaction.

BofA's crosstown rival Wachovia (WB, Fortune 500) - both are headquartered in Charlotte, N.C. - is expected to report a steep drop in fourth-quarter earnings next week as well.

Two banks that could buck the broader trend are JPMorgan Chase (JPM, Fortune 500) and Wells Fargo (WFC, Fortune 500), which are also slated to report results next week.

While both firms are expected to post a decline in profits, their earnings shouldn't be as disastrous, and executives at both firms have publicly stressed the health of their companies' respective loan portfolios.

Granted, much of this week's focus will be on the size of the writedowns all the big banks take. But Wall Street analysts will also be watching several other key areas, including the health of these companies' different businesses and the credit quality in their portfolios.

One area of concern among analysts covering mortgage-focused banks like Washington Mutual and Wells Fargo is how commercial real estate portfolios are holding up, an area that some suspect could be the next spot of trouble in the credit markets.

"If it does happen, that's another whole leg down for these banks," said Paul Miller, an analyst with Friedman, Billings, Ramsey & Co., regarding the possibility of a commercial real estate slump.

Also in focus will be the banks' net interest margins - a key metric that measures the profits banks make from taking in deposits and lending them back out.

Recent cuts in short-term interest rates by the Federal Reserve would normally bode well for net interest margins because rate cuts usually allow the banks to offer lower yields on CDs and money markets. But competition for customers has been so tough that the banks have been unable to cut their deposit rates as much as they would have in the past.

Analysts think some banks may also announce major restructuring moves when they report earnings.

A number of reports have surfaced recently suggesting that Citigroup could cut as much as 10 percent of its workforce or reduce its dividend, which yields an attractive 7.6 percent.

And there has been speculation that both Citi and Merrill could sell some assets in order to raise additional capital. Merrill has already sold its consumer finance unit to General Electric Co. (GE, Fortune 500) while reports have surfaced that Citi could shed its stakes in Student Loan Corp. or the Brazilian credit-card company Redecard SA.

Although it is certain that the results for the fourth quarter will be bleak, it doesn't look like the worst is over just yet. Banks will have to at endure at least another two quarters of pain before they start to see any relief, said Mendon Capital Advisors' Barkocy.

"Many [banks] are looking to the second half of the year to be significantly better than the first," he said.

But for bank stock investors, the second half of 2008 is an eternity away.