Bankers love talking these days about going back to basics, but the basics weren't very cooperative in the third quarter.
When regional banking companies begin reporting in earnest on Wednesday, their financial results are expected to confirm two things: Loan demand remained anemic, and declines in yields on the securities taking up more and more room on banks' balance sheets outpaced the decline in deposit costs.
Without the diversified income streams of their money-center counterparts, regional bank companies were all the more exposed to intense pressure on net interest margins.
Their ability to keep investor concerns contained this earnings season and beyond will depend largely on the extent to which they can offset the margin compression, be it with mortgage banking activity, accelerated improvements in credit quality or continued reductions in funding costs.
"Despite expectations for a generally in-line quarter, we don't expect quality will be strong, and we are cautious about the risk to forward earnings estimates based on net interest margin pressures and continued loan portfolio shrinkage," Paul J. Miller Jr., an analyst at FBR Capital Markets, wrote in a research note previewing third-quarter results.
He said he favors larger regionals such as PNC Financial Services Group Inc. and U.S. Bancorp for their efficiency, large reserves and relatively diversified revenue sources. Estimates tallied by Zacks Investment Research show that analysts expect third-quarter earnings per share to rise 60% year-over-year at PNC, to $1.60, and 43% at U.S. Bancorp, to 43 cents.
Miller also saw good prospects for New York Community Bancorp and Texas Capital Bancshares Inc., which he said should benefit from last quarter's strength in mortgage banking thanks to refinancings.
But even the best-positioned banks must contend with the protracted slump in loan demand, which is dampening the potential for fee revenue and the reshaping of banks' balance sheets. Federal Reserve data shows that loans were less than 57% of total assets on commercial banks' books at Sept. 29, the lowest share in recent memory, and that securities accounted for more than 20% of assets, the highest since 2006.
"Investment securities portfolios are likely to continue to grow, given the lack of loan demand and as banks look to stabilize earning asset balances," Morgan Keegan & Co. analyst Robert Patten warned.
Unfortunately for banks, or at least for those hoping to see better net interest margins, yields on investment securities such as Treasury and agency debt have fallen precipitously. The yield on the benchmark 10-year Treasury note dropped from about 2.93% at the start of the third quarter to 2.48% at its end. This has negative implications for big holders of mortgage securities, such as Hudson City Bancorp, as low rates spur a refinancing wave that probably reduced net interest margins.
"As borrowers roll their higher-rate mortgages into longer-duration, lower-rate loans, we think it is going to be increasingly difficult for the company to reprice its funding costs down as quickly," said Mark Fitzgibbon, an analyst at Sandler O'Neill & Partners LP. "We think this could pressure third-quarter earnings a bit more than people expect."
The average profit forecast for Hudson City is 26 cents a share, off a penny from the year earlier.
Several analysts said they expect banks will soon start monetizing the gains on their securities and using the proceeds to pay down more expensive borrowings as the debt matures. Until then, they will need to find other ways to fight margin pressures.
Some banks still have enough room to reprice higher-cost deposits and are expected to boost their net interest margins from levels seen in the second quarter. Keith Horowitz, an analyst at Citigroup Inc.'s Citi Investment Research division, said he expects margins to expand by 14 basis points at Fifth Third Bancorp, to 3.71%, and by 13 basis points at KeyCorp, to 3.3%. Both companies are expected to reverse their losses from last year's third quarter. Fifth Third is expected to report earnings of 17 cents a share, and Key, 3 cents a share, according to Zacks.
Horowitz named several areas in which banks might surprise investors on the upside this earnings season, including better-than-expected margin trends, strong revenue from mortgage banking activity and a smaller-than-anticipated impact from new overdraft regulations, which took effect July 1. Several banks reported last quarter that more customers than expected were opting into overdraft protection, tempering the impact the new rules would have on overdraft fee revenue.
On the credit front, most big regional banks are expected to report improvements, with fewer loans categorized as nonperforming and loan-loss reserves in some cases starting to drop. Fifth Third, SunTrust Banks Inc., Iberiabank Corp. and Marshall & Ilsley Corp. are among companies seen as likely to have benefited from improved credit trends.