Banking Sector Still Solid, Despite Setbacks

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The fallout from the 2008 mortgage crisis continues to affect the nation’s big banks. The most recent development involves the Federal Deposit Insurance Corporation, which is suing several of the banks for their roles in the failure of two banks that bought mortgage securities from them.

The banks named as defendants in the lawsuit include JPMorgan (NYSE: JPM), Citigroup (C) and Bank of America (NYSE: BAC). Ironically, the news of the lawsuits came within days of the FDIC releasing a report about how the banks were among those that it insures that increased revenues during the first quarter of 2012.

Others named in the lawsuit are Credit Suisse (CS), Deutsche Bank (DB), Royal Bank of Scotland (RBS), UBS (NYSE: UBS) and HSBC (HBC). The civil lawsuits were filed in New York federal court.

The lawsuits entail mortgage-backed securities the firms sold to two banks in Illinois. These banks, Strategic Capital and Citizens National Bank, failed and were subsequently seized by the FDIC in 2009. The FDIC charges that the defendants misled and deceived investors about the risks of mortgage-backed securities. 

As these lawsuits are handled, the banks should still be able to stay on track in terms of their earnings. In the earnings report released in May by the FDIC covering the first quarter of fiscal 2012, banks showed that they have steadily improved since the financial crisis that threatened to ruin them. According to the FDIC, the banks it insures posted their 11 consecutive quarters of earnings that were higher than the year before. The FDIC states that the commercial banks and savings institutions it insures had an aggregate profit of $35.3 billion in the first quarter of 2012, which was a $6.6 billion improvement from the $28.8 billion in net income the industry reported in the first quarter of 2011. 

While that is good news, the FDIC noted it was concerned about the decline in loan balances for the banks. They decreased by $56.3 billion, or .8% after three consecutive quarterly increases. Still, the agency says too much should not be drawn from this increase because this drop was just for one quarter.

The year-over-year earnings improvements were largely due to lower provisions for loan losses and higher non-interest income, according to the FDIC. Loss provisions were roughly $14 billion, which was nearly one-third less than the $20.9 billion that insured institutions set aside for losses in the first quarter of 2011. Furthermore, net operating revenue increased by $5 billion, or 3.1%. They totaled almost $170 million. Another area that experienced increases relates to investment securities and other assets. They were up $2 billion from the first quarter of 2011.

Net income for more than two-thirds of the institutions the FDIC insures increased. Institutions reporting net losses for the quarter fell to 10.3% from 15.7% during the first quarter of 2011. The average return on assets rose to 1.02% from .86% a year ago.

These strong numbers are reflective of the major changes banks have had to make to improve their finances following the 2008 financial collapse. In fact, just one year ago financial stocks were the worst performers of the 10 industries tracked by the S&P 500 index. Now financial stocks are the second leading sector in the S&P 500. Its gains are around 18%, which compares to an 11% gain in the broader sector.

Now let’s look specifically at Bank of America, which made headlines last year for agreeing to the largest settlement of all of the banks regarding its role in the mortgage debacle. It agreed to pay investors $8.5 billion in an attempt to make them whole after selling them the fraudulent mortgage-backed securities.

The controls it put in place following the financial meltdown of 2008 seem to be paying off.  Its shares have now returned 29% year-to-date following a 58% decline in 2011.

As a result of the settlement, and other mortgage-related matters, Bank of America reported an immediate loss of $8.8 billion or $0.90 per diluted share for the second quarter of 2011. That compared to having a net income of $3.1 billion, or $0.27 per diluted share during the second quarter of 2010.

It last reported earnings in April, and that was for the first quarter of 2012. There were improvements, including beating Wall Street estimates. Its earnings clearly reflected how much the mortgage debacle affected the bank’s finances. Its net income was $653 million, or $0.03 per diluted share, for the first quarter of 2012. The results compare to a net income of $2 billion, or $0.17 per diluted share during the first quarter of 2011.

Bank of America is not alone in its efforts to regain its financial footing following the 2008 housing crisis. It, like the other banks I’ve mentioned, must continue to control their spending and expenses. Their challenges in controlling their expenses are only compounded by the fallout of the housing mess. I think that more will also have to make huge payouts similar to Bank of America’s $8.5 billion agreement.

I think the financial sector as a whole is a good investment. While financial stocks are performing so far this year, there are several things investors should be mindful of that could affect them. This includes the European debt crisis, political uncertainty as we approach the November elections, and the effect of regulatory reform. Efforts to further beef up regulations concerning financial institutions will likely continue, especially in light of JPMorgan’s announcement in May that it will lose at least $2 billion due to dabbling in the risky derivatives market. 


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