Earnings Preview: Regional Banks

At the end of 2006, the main straitjacket squeezing banks was the inverted yield curve or high costs to raise money coupled with paltry yields from lending it.

While the yield curve improved this year though probably not for the reasons banks would have liked a raft of new problems began cropping up.

Tumbling home prices have hampered people's ability to repay their home loans. When a person's house loses value, he loses both the means and the incentive to pay off his mortgage.

This has forced most banks to bolster their reserves of cash slated to cover unpaid loans. When banks pad their reserves, they have to funnel cash from what would have been their profits.

Jason Goldberg, an analyst with Lehman Brothers, said these reserves as a portion of banks' assets shrank for much of 2001 through 2004, then stabilized. Now, they are beginning to rise again.

He foresees the potential for more provisions and losses on construction and development loans, which comprise 9 percent of banks' loans, and home-equity loans, which comprise about 8 percent.

The decay of credit quality at banks has not been kept a secret. The Nasdaq Bank Index fell more than 20 percent this year, and it is common for bank stocks to have fallen 30 percent or more for 2007.

The principal question now, said Banc of America Securities analyst John E. McDonald, is whether the stocks have fallen enough to predict how drastically credit will deteriorate.

Banks are in the early stages of a cycle of weakening credit, McDonald said. Stocks in the sector are predictively weak, as it appears "conditions will only get worse before they get better."