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Regional Banks Navigate Choppy Operating Conditions 1st Q

by Kevin Dobbs and Marshall Schraibman, SNL financial

(With no. 1 U.S. mortgage lender Wells Fargo (NYSE:WFC) set to report Q1 earnings today and several regional banks reporting in coming days, analysts expect results to take a hit from an expected drop in mortgage revenue. Jefferies estimates banks' revenue from originating mortgages could decline 15%-20% Q/Q; "the magnitude of potential declines could catch some [investors] off-guard.")

"... most banks are much better off than they were a few years ago, when the aftermath of the 2008 financial crisis and accompanying recession rocked the industry. But the first quarter likely will mark a slow start to what could be a modest year."

Frank Barkocy, director of research at Mendon Capital Advisors Corp

Large U.S. regional and trust banks, while collectively well capitalized and on solid footing in terms of credit quality, continued in the first quarter to grapple with pressures on interest income and their margins amid a tepid economy and prolonged low-interest rate environment.

"The general feeling is that, along with the margin pressure, loan demand started to slow down in the quarter, and that will be an issue for many," Frank Barkocy, director of research at Mendon Capital Advisors Corp., told SNL. "And mortgage banking, while probably holding up some in the first quarter, could start to become a negative factor."

Many regional lenders reported decent loan growth in the final quarter of 2012, as clients drew on credit lines or sought new loans ahead of tax hikes that lurked around the turn of the new year. But as the impact of payroll tax increases gradually took hold and uneven economic conditions fostered uncertainty, many customers are thought to have pulled back on credit demand in the first quarter, crimping interest income. Meanwhile, Barkocy said, low rates that have persisted in the wake of Federal Reserve policies aimed at keeping them near rock-bottom levels have squeezed banks' net interest margins, further eroding earnings.

Among 15 major regional and trust banks analyzed by SNL Financial, only two - Capital One Financial Corp. and Northern Trust Corp. - are expected by analysts, on average, to report increases in interest income when their first-quarter results, to be released this month, are compared with the fourth quarter of 2012. And only two - Capital One and Bank of New York Mellon Corp. - are projected to report bumps in their NIMs.

At the same time, one important business line that many regionals have relied upon to juice earnings in recent quarters - mortgage banking, which has benefited from customers refinancing their home loans to capitalize on low rates - shows signs of slowing this year, Barkocy and other analysts say, as a large swath of the creditworthy customers seeking to refinance has already done so at today's historically low rates. He expects mortgage banking results in the first quarter to be good, but for many, it will be down from previous quarters.

A team of analysts at Evercore Partners, addressing in a report the prospects for a large group of regional banks, predicted a median NIM compression of 5 basis points and added that "downside risk remains significant." The analysts, citing intra-quarter guidance from several bankers, also said they anticipate mortgage banking revenue to decline 3% from the linked quarter.

And while credit quality continues to improve for most, the large benefits many banks enjoyed over the last couple years from declining credit costs are expected to dissipate notably this year, as most lenders have brought provision levels down to near where they will level off. In fact, of the 15 companies examined by SNL, seven are projected to report increases in provision levels for the first quarter.

Sandler O'Neill & Partners LP analyst Alexander Twerdahl summed it up this way in a report: "For the most part the industry is well (and arguably over) capitalized and the credit environment is moving full steam in the right direction (NPAs have been declining for over 2 years). But, the operating environment for banks is only becoming more challenging. Earnings levers that existed in 2012, including credit leverage, lowering funding costs, and mortgage banking, will be more difficult to pull in 2013. NIMs will continue to compress as rates remain low and the yield curve remains flattish. Loan growth is becoming harder to find and the competition for what demand is out there is as fierce as it has ever been."

So it stands to reason that analysts anticipate reports of declining revenue and net income. Among the 15 companies examined by SNL, the Street expects 12 to report first-quarter revenue levels that are down from the previous quarter. Analysts forecast that 10 will report declines in net income.

Many lenders will offset the headwinds via cost cutting, Barkocy said, noting that myriad banks have been trimming headcounts, closing branches and consolidating back-office operations to bring expenses in line with revenue.

"I think we'll get somewhat better expense controls showing" in the first quarter results, Barkocy said, "as many banks took to heart a need to become more efficient."

All of that noted, Barkocy said, most banks are much better off than they were a few years ago, when the aftermath of the 2008 financial crisis and accompanying recession rocked the industry. But the first quarter likely will mark a slow start to what could be a modest year.

"I think it will be an OK but not great quarter," he said.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.