While showing signs of life, the still-fragile banking industry — and the U.S. economy — face a critical test as companies head into earnings season.
Banks announcing first-quarter earnings can expect extraordinary scrutiny from investors and government officials alike, with any letdown threatening to throw the sector, which has rallied of late, into another tailspin. That, in turn, could have grave repercussions not only for the industry, but for the country as a whole.
Banking companies themselves have raised the stakes. Kenneth D. Lewis at Bank of America Corp., Vikram Pandit at Citigroup Inc. and James Dimon at JPMorgan Chase & Co. have predicted that their companies would turn a profit. Wells Fargo & Co. on Thursday did its part to boost expectations by issuing a bullish, if incomplete, preview of its first-quarter results. (See related story.)
"The CEOs have taken a stand and expectations have been raised, particularly for those who enunciated that they were doing well," said Frank Barkocy, the director of research at Mendon Capital Advisors. "There is considerable pressure to report numbers consistent with what management has already stated," he said. Financial companies "could get slammed if they don't perform."
Wall Street, too, has shown a renewed faith in financial companies. The bank research team at KBW Inc.'s Keefe, Bruyette & Woods, for instance, forecast that industry results could be up 9.3% from the fourth quarter, though still off an astounding 39% from a year earlier.
Still, huge questions remain unanswered, including what will happen if banks are unable to live up to such expectations even as their nonperforming assets continue to climb and their reserves keep swelling.
"A lot of banks are struggling" despite the handful of positive vibes from the big banks, said Mark Fitzgibbon, the head of research at Sandler O'Neill & Partners LP. It is likely there will be less emphasis on overall this time around, he said.
"There is a much more heightened focus on where credit is headed and if they have the capital to ride out the storm," Fitzgibbon said.
Also raising the stakes for companies reporting results are the government's stress tests for the biggest banks and what is expected to be the most contentious series of annual meetings in recent memory. What transpires in late April and beyond could lift the sector — or sow new doubts.
"It is enormously important for people to see that commercial banks can still make money despite their assets," said Brian J. Fabbri, the chief economist for North America at BNP Paribas. "Financial markets have to return to some form of normalcy and provide credit before the economy can grow again … and the government programs to date haven't been successful enough at doing that."
Weak financial results could ratchet up tensions at annual meetings already expected to be contentious, with investors at many companies asked to approve executive compensation packages, for companies that accepted funds from the Treasury Department's capital purchase program.
Another possible danger is government intervention after the stress tests and the impact that could have on management teams and shareholders. A number of banks may have to follow Citi's lead by converting preferred stock from the CPP to common stock to bolster tangible common equity. Observers also pointed to recent comments by Treasury Secretary Timothy Geithner that the government might remove executives and directors from banks that need additional capital. The Treasury has indicated that it will not release any results from the stress tests until after earnings are reported, leading analysts to believe that CEOs will say little, if anything, about the process during their conference calls.
Robert Patten, an analyst at Regions Financial Corp.'s Morgan Keegan & Co. Inc., said pressure on other chief executives could intensify if their companies show poor results. "People have lost a lot of money, and I think the annual meetings will be even more combative," he said. "There are many CEOs who are also on pins and needles right now" because of looming political risks and the government's recent removal of General Motors Corp. CEO Rick Wagoner, said Patten, who is advising clients to avoid loading up on bank stocks until next month.
Even healthier companies expected to disclose stronger first-quarter results face land mines. Dimon at JPMorgan Chase has talked optimistically about investment banking at the $2.2 trillion-asset New York company, and analysts believe banks as a whole will benefit from their fixed-income desks. Meanwhile, B of A's Lewis has touted refinancing activity at Countrywide Financial Corp., the distressed mortgage lender the $2.5 trillion-asset Charlotte company bought last summer.
Such comments have prompted growing concern that banks are continuing to rely on cyclical fee businesses as a profitability backstop, which in turn could lead to renewed questions from investors about the business model's long-term viability. Credit quality is still expected to deteriorate at an accelerated rate, with the potential to spread more from its consumer origins into commercial lending.
"It doesn't tell me about the rest of the banking activity that is going on," Fabbri said. Though he expects big banks to show profits, Fabbri wondered if some would use earnings in investment banking to absorb "writedowns of assets elsewhere that are undoubtedly in trouble."
Michael Mayo at Credit Agricole Group's Calyon Securities LLC estimated in a recent note that he expects loan losses to hit 3.5% by the end of next year. Profits, he wrote, "should get hurt more than in the past given a greater portion of market-sensitive fees, higher deposit insurance and fallout from a higher-risk securities portfolio."