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Storm Clouds Gather for Banks

It’s been a bad year for banks.

Over the past twelve months, the KBW Bank Index—which tracks the share prices of large money center banks and significant regional banks—has dropped 6.96 percent. The S&P 500 stock index has risen 17.05 percent during the same period.

Some analysts think that bank stocks are ripe for a comeback, especially if the economy expands more rapidly in the second half of the year.

But there are several dark clouds looming over banks that could lower profits, distract management, and perhaps keep them from fully participating in the recovery.

A Housing Double Dip

The great debate about housing is whether the market has gone over the edge of a double dip or is rapidly plunging into a bottomless abyss.

Over twenty-eight percent of homeowners with mortgages are underwater. In the past year, the share of underwater borrowers who say it is okay to walk away from a mortgage has doubled, rising to 27 percent. This is a recipe for a coming jump in default rates if economic distress picks up.

Foreclosures have slowed to a crawl thanks to massive red-tape delays—which means it is taking banks much longer to recover value on soured loans. Home prices are dropping again—further reducing the recovery values when banks foreclose.

Bank continue to hold massive amounts of mortgages and mortgage-related assets on their balance sheets. Many of these have been marked down substantially. But if mortgages go into meltdown mode again and housing prices keep falling, banks will see revenues from these assets decline and losses creep up again.

Investigations, Lawsuits, Regulations

There seems to be no end to the legal troubles facing the banks.

Today we learned that the New York Attorney General is investigating the bubble-era mortgage businesses of several banks—including Goldman Sachs, Morgan Stanley and Bank of America.

Add to that the Huffington Post’s report of confidential federal audits that accuse the nation’s five largest mortgage companies of defrauding taxpayers.

The Commodities Futures Trading Commission has told Goldman it intends to bring aiding and abetting, civil fraud and supervision-related charges against the company's clearing services. Goldman is also facing an investigation into communications among its analysts, sales and trading staff, and clients.

And an oversight report from a Senate subcommittee has raised fears of a Department of Justice investigation into Goldman that could result in criminal charges.

Meanwhile, the big banks continue to face lawsuits from investors in mortgage backed securities and companies that insured them. These lawsuits demand the banks buy back the securities that have gone bad on the grounds that they were badly flawed from the start. Banks are setting aside billions to cover these lawsuits—but no one really knows how much they might have to pay out.

Bank of America has gone so far as to hire the former chief of the SEC’s enforcement division to be its lead lawyer—which may be a hint that it expects its legal troubles to keep getting worse.

Regulatory uncertainty is still the watchword when it comes to banks.

The consumer finance protection agency is supposed to be in place later this year. It may wind up imposing a plethora of restrictions on the types of loans and investment products banks can offer consumers, and restrict what kind of fees they can charge. And we still do not know the final shape of Volcker Rule restrictions on trading and principal investing.

A Warning Sign: CFOs Resigning

The chief financial officers of both Wells Fargo and Bank of America recently resigned. JPMorgan Chase replaced its CFO last year. While each of these moves has been spun as benign news by the banks, it could be a warning sign that something is deeply amiss.

Where Will Profits Come From?

The largest banks did very well trading in the first quarter of the year. But many of the smartest minds in the market expect the second half of the year to be much tougher. SAC Capital founder Steve Cohen, for example, said at the SALT conference last week that he expects markets to “pause.”

The demand for loans remains very light. The housing market is too sluggish to create serious growth in mortgages. Corporate balance sheets are flooded with cash, which decreases their need to borrow.

The potential for economic growth to slow down again in the second half of the year or perhaps 2012 may put a damper on corporate expansion, further reducing the demand for loans. JPMorgan Chase announced that it reduced lending by 1 percent in the fourth quarter.

Reduced demand for loans could make rising interest rates painful for banks. Typically, banks profit during periods of rising rates because they can raise rates on loans they make faster than they have to raise rates on interest on deposits. But low demand for loans could make this more difficult. And rising rates also increase the costs to banks to fund their own operations, which makes everything from lending to trading more expensive.

A Few Bright Spots

There are a few bright spots. Many adjustable rate mortgages are resetting at much lower rates—which could put a damper on mortgage defaults. Merger activity is picking up—and the fees from these deals could boost profits for banks. It’s unlikely that the government will do anything drastic to pull back on its support for the housing market or the GSEs.

Most importantly, banks still employ many clever people who stand to make fortunes by figuring out how to profit from unlikely circumstances. Perhaps there is some clever team of men and women somewhere on Wall Street building the next great financial gravy train.

But absent some innovative leap toward a new source of profits, the picture looks bleak for banks.

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