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Bank Shares Take a Beating, and It May Not Be Over Yet

Michael Scanlon is tempted by bank stocks, truly he is.

They are cheap — selling at near their lows for the year, and trading at well below the valuation of other large companies.

But Mr.Scanlon, who helps oversee $7.5 billion for the John Hancock family of mutual funds in Boston and specializes in financial companies, is not about to give in and buy more shares.

“It’s just not going to be a smooth ride,” he said. “You wake up every day and there’s a new headline and a new concern.”

Bank stocks took another tumble late last week after Moody’s , the credit rating firm, warned it might downgrade the debt of giants like Bank of America , Citigroup and Wells Fargo as the government eases back on support for the sector.

Even as the market absorbed that news, reports that Goldman Sachs had been subpoenaed in an investigation by the Manhattan district attorneyfurther unnerved investors, and sent that giant investment’s bank’s shares sinking.

Pessimism about the sector was reinforced by weaker-than-expected economic data, including a bleak reading on unemployment on Friday.

What’s more, well-known hedge fund investors like John A.Paulson and David Tepper have been quietly selling the big positions in the sector they had earlier amassed, a sign the smart money has already begun to bail.

Mr.Tepper, in particular, had made huge profits by scooping up beaten-down bank stocks when they bottomed out in late 2008 and early 2009 in the midst of the financial crisis and riding their subsequent recovery.

But in the first quarter of 2011, he sold off about a third of his positions in Citigroup and Bank of America.

For Mr.Tepper, the timing was impeccable.

Since the beginning of April, the KBW Bank Index has dropped 8 percent, compared with a much more modest 2 percent decline in the benchmark Standard & Poor’s 500-stock index.

Last week, bank stocks sank to their lowest point since early December.

For individual investors, who have long favored bank stocks as a source of dividends and at least the promise of stability, their recent performance has been a big disappointment. And few experts expect a turnaround anytime soon.

“I haven’t seen investor sentiment this bad in a long time,” said Jason Goldberg, a longtime bank stock analyst at Barclays. “Not owning the group has been the right call, and people are skeptical about getting back in.”

By many measures, the sector is pretty cheap. Diversified banks are trading at about 9.4 times earnings, compared with a multiple of 12.4 for the broader S&P 500, according to FactSet Research.

But then, they may deserve to be selling at a discount.

Besides the worries about a possible debt downgrade and the investigations into the role they played in the financial crisis, major banks are facing headwinds on many fronts.

For starters, federal regulations passed last year are set to cut deeply into revenue on everything from debit card transactions to trading on Wall Street.

The restriction on debit card fees, known as the Durbin Amendment after the senator who proposed it, Dick Durbin of Illinois, could alone cost the top 25 banks roughly $8 billion in lost revenue, Mr.Goldberg said.

The new regulations are set to go into effect on July 21, although Senator Jon Tester, Democrat of Montana, is pushing a proposal on Capitol Hill that could come up for a vote as early as next week that would delay their start by 15 months.

Even if Mr.Tester wins a reprieve for the banks, other rules in the broader Dodd-Frank bill, which overhauled financial regulations, could cost the industry another $8 billion, according to Mr.Goldberg.

In addition, new international rules now being developed to require major institutions to hold more capital as a buffer against future financial crises will also erode profitability.

That is because money set aside as ballast is cash that will not be available to lend out or pay dividends or buy back stock.

More than any of the changes hurtling toward them is a more fundamental problem that banks face — revenue is stuck in neutral.

And a huge chunk of profits is not coming from the actual business of lending money, but instead represents gains from the release of reserves set aside in the past for possible loan losses.

As these costs have eased, that money for a rainy day has fallen to the bottom line. In the first quarter of 2011, the top 20 banks earned $27.5 billion in pretax income.

Nearly $11 billion, or 40 percent of that, came from the release of reserves, according to Mr.Goldberg. The proportion was even higher in the fourth quarter of 2010, when it hit 54 percent.

While that money has helped camouflage anemic revenue and lackluster loan growth, it is hardly a long-term strategy for sustainable profit increases.

Then there are the legal headaches.

The biggest banks face another threat from an investigation into mortgage servicing abuses by all 50 state attorneys general, who are pressing for a settlement of $20 billion or more.

The banks themselves are holding out for a much more modest payment of $5 billion, and though the momentum has shifted in favor of the banks lately, the uncertainty about how big the inevitable hit will be has further undermined shares.

Even if the banks are able to avoid a giant settlement, a potentially more expensive headache is the effort by private investors to force them to buy back soured mortgage securities.

The industry has already set aside billions for these claims, known as “put-backs,” but tens of billions in potential losses still loom.

As badly as the broader sector has performed, some banks have held up better than others.

Bank of America has been among the worst performers, falling 15 percent since the beginning of April to close at $11.28 Friday, hurt by a lackluster first quarter and persistent worries that its huge portfolio of troubled mortgages will sap earnings for years to come.

Similarly, Wells Fargo has declined 15 percent to $26.86, another victim of mortgage-related worries, as well as its dependence on the United States economy for the vast bulk of its business.

Citigroup, which has more exposure to faster-growing international markets, has fallen 10 percent to $39.85 over the same period, although results in its investment-banking business were weak in the first quarter.

It also resorted to a 1-for-10 reverse stock split to lift its share price out of the single digits, a move usually reserved for penny stocks and other shaky investments.

JPMorgan, at $41.57 a share, is also off 10 percent, although analysts say its underlying earnings power is much stronger than that of Bank of America or Citigroup, and it has been using extra capital to buy back stock and raise its dividend.

In fact, the Federal Reserve vetoed Bank of America’s plan to increase its dividend in March, even as it permitted rivals like JPMorgan, Wells Fargo and others to raise theirs.

Goldman Sachs, meanwhile, ended the week at $135.33, not far from its 52-week low of $129.50.

“It’s hard to look past what’s going on right now,” said Mr. Scanlon, the John Hancock analyst. “Who knows what I’m going to read tomorrow?”