The largest U.S. banks have had a strong run of late with the SPDR KBW Bank ETF KBE-N roughly doubling in the past year. We've pulled together five reasons to be cautious about their prospects from here.
1) Second Foreclosure Wave
Roughly five to seven million home owners are technically in default, but have not yet been foreclosed upon, according to a report last week from The Washington Post .
Most of the most worrisome exposure to troubled U.S. mortgages lies with government-sponsored lenders like Fannie Mae FNM-N and Freddie Mac FNM-N, according to a report from Oppenheimer & Co. analyst Chris Kotowski, who describes home lending as "the biggest single threat to our generally positive view of the banking industry" in a recent note to clients.
If the fragile economic recovery doesn't cooperate, and it turns out loan losses haven't quite peaked, the usual big bank suspects -- Bank of America BAC-N, Citigroup C-N, Goldman Sachs GS-N, JP Morgan Chase JPM-N, Morgan Stanley MS-N, and Wells Fargo WFC-N (and the rest of the market) -- could be in for another round of pain.
2) Government Stimulus Removal:
The Federal Reserve has pumped $1.25-trillion (U.S.) into the U.S. mortgage market -- effectively by buying debt obligations of Fannie Mae and Freddie Mac, and by purchasing mortgages they underwrote. This massive intervention stabilized mortgage markets after it was announced in November 2008.
But the Fed's program is set to end this month, and it remains to be seen whether private lenders will pick up the slack.
There is also the question of how well the markets will digest eventual short-term interest rate hikes. Mike Cosgrove, principal at research firm Econoclast, expects a 50 to 75 basis point increase in the Fed funds rate, which he thinks the markets will be able to handle. However, many economists worry the Fed will be too slow to tighten monetary policy, which could spur inflation. Banks would likely perform poorly in such an environment, as the loans on their books would drop in value.
3) Regulatory Threats Resurface:
Bank stocks came under pressure in January as President Obama revealed tough new proposals that seemed to threaten the very existence of the largest of the breed. Reform legislation hadn't made much headway since then but this week's draft of a comprehensive bill by Senate Banking Chairman Christopher Dodd (D., Conn) could lead to the effort picking up some steam.
Dodd's bill, dubbed the Restoring American Financial Stability Act of 2010 would not break up big banks outright, and it does appear to allow more wiggle room on areas such as derivatives and consumer protection than many in the banking industry had feared might come down from Capitol Hill.
But the bill still does share some philosophical DNA with the so-called Volcker rule designed to limit proprietary trading that spooked many bank investors back in January, and if passed in its current form, it would increase government supervision and powers.
The wild card is the mid-term elections in November. If the Democrats fare poorly, they may decide to redouble their efforts to get tough on banks, as President Obama did after Republicans stunned the country by winning the Massachusetts Senate seat vacated by the late Ted Kennedy.
