Why Underdog Banks May Lead Market

Amid all the kerfuffle over Europeans outing their weak banks, it seems people have forgotten how surprisingly strong the US banking system has become.

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The six largest American banks earned nearly $15 billion, or $3.87 per share, for common stockholders in a single quarter — despite huge challenges ranging from market volatility to concerns about a double-dip recession to the political winds blowing harder against their core business models.

What may be even more surprising is that Wall Street's underdogs have become champions as the industry prepares to face enormous regulatory changes.

To begin, Morgan Stanley did far better than Goldman Sachs in trading, investment banking and asset-management during the second quarter.

And Wells Fargo had the sunniest results of any of the Big Four money-center banks.

I'll say that again for those who may think it was a typo: Morgan Stanley kicked Goldman's rear end, and Wells Fargo kicked everyone else's.

Morgan Stanley's trading revenue was down, but much more resilient than other Wall Street firms against a volatile and uncertain backdrop. Trading is an area in which Morgan Stanley has a history of disappointing, so the strength was that much more of an upside surprise.

Morgan also "bucked the industry downtrend," as Sandler O'Neill analysts put it, to report flat investment banking revenues, while Goldman's numbers were...well, pretty sad.

Additionally, Morgan Stanley indicated that it is pulling out the big guns in asset management, an area that it seems very wise for a Wall Street bank to target right now.

Politicians and regulators are fine with a firm collecting fees to replenish America's 401(k)s, and so is the voting populace. But they're targeting most of the other things Wall Street banks do to make money — apart from deal-making and securities offerings, which are harder to come by these days. Corporations are hesitant to expand and investors are hesitant to give them funds to do so.

One could have sympathy for Goldman Sachs' lackluster results: The bank had enough on its hands during the second quarter.

Goldman was battling the SEC over a vintage derivatives deal, cast as having been smarter than everyone else — including some clients — by betting against the housing market early. But, ironically, Goldman blamed its second-quarter revenue miss on "significantly lower results in derivatives" as well as "principal strategies" - something that a titan of Wall Street ought to be best at.

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Furthermore, Morgan Stanley's successes were delivered against a backdrop of enormous volatility, a "flash crash" whose cause is yet to be determined, a financial-reform bill that changes the way Wall Street operates and increasing concern about a "double-dip" recession.

As for Wells Fargo, the reaction to its quarterly earnings beat was a stark difference to Bank of America's , JPMorgan Chase's or even Citigroup's just a few days earlier. JPMorgan's report was sprinkled with cautious sobriety; Citigroup's was colored by the usual uncertainty; and Bank of America's management was just downright depressing.

The big bank stocks largely reflected that somber tone until last Wednesday, when the reports from Morgan Stanley and Wells Fargo came through.

To be sure, there were some negative items in Wells' report and conference call, such as a hedging strategy whose impact is waning and analysts' skepticism about strong net interest margins and the profitability of Wells Fargo's loan portfolio. But management's sanguine view of financial reform, its measly cost estimates and its strong top and bottom lines restored some confidence in financial stocks.

"In my view, Wells Fargo has a banking franchise second to none in this country," CEO John Stumpf said on the conference call.

Apparently the market agrees: Wells' stock surged as much as 6.5 percent on the day of its earnings release. Though it gave up some of those gains by the close, the shares finished last week at $27.42, up 5.8 percent from their close prior to the release. Similarly, Morgan Stanley's stock has jumped 8.5 percent since its finish in the session before its results were released, ending the week at $26.89.

If nothing else, the second quarter proved that Wall Street will survive — it'll just look a little different — and that being the big bank on Main Street may not be such a bad thing after all.

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Disclosure information was not available for LaCapra or her company.

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