SIVY ON STOCKS from money.com
June 6, 2001

Why aren't banks doing better?

Interest rate trends couldn't be more favorable, but leading banks such as
J.P. Morgan and Bank One can't get any traction.

By Michael Sivy

If I were asked to name the single most important stock market indicator,
I'd say the tilt of the yield curve. When long-term interest rates are at
least half a percentage point higher than short-term rates, the economy
typically grows at a healthy rate. But when short-term rates are even with
or higher than long-term rates, the economy almost always stagnates or
starts contracting. The yield curve is especially important for banks,
since they have to borrow short-term money that they lend to long-term
borrowers. The difference between short- and long-term rates, therefore, is
a rough gauge of banks' profit margins.

After five cuts in short-term interest rates this year by the Federal
Reserve, the difference between short and long rates is two full percentage
points. With loan margins that fat, you'd think that the top U.S. bank
stocks would be in great shape. But they aren't. Shares of leading banks
such as J.P. Morgan Chase [JPM] and Bank One [ONE] are flat to down so far
this year. And both stocks have announced that their earnings for the
current quarter will be below what analysts were expecting. What's the
explanation for the lousy results?

Essentially, there are two problems. Many of the big banks lent
aggressively during the boom of the past five years and now find themselves
saddled with lots of problem loans. In the case of J.P. Morgan Chase, those
loans are to tech firms, such as telecoms. Bank One's problem loans, by
contrast, represent credit-card debt. But in both cases, the banks will
have to clean up their portfolios before they can truly profit from the
improved interest-rate environment.

Global giants, such as J.P. Morgan Chase, have a second set of problems.
Over the past five years, their earnings became increasingly dependent on
investment banking activity, such as IPO underwriting, private equity
investments and proprietary trading. All of those businesses are depressed
and will likely remain so until the tenor of the market improves
substantially. And even though the Nasdaq is up 35 percent from the April
lows, J.P. Morgan's losses on past investments are still outpacing its
gains on those that are recovering.

Where does that leave the stocks? Basically, they have a lot of sewage to
wade through for the rest of this year. But they should be coming back
strongly by the start of 2002. And, of course, share prices normally
anticipate such improvements by at least a few months.

I recommended J.P. Morgan Chase in January at $53 a share, saying the bank
faced a rough six months, followed by accelerating growth over the coming
three years. That scenario is unfolding more slowly than I expected, and
the share price has declined by six bucks. But for long-term investors, I
continue to believe that this is the must-own bank stock. However long it
takes to clean everything up, the bank will be a powerhouse a couple of
years from now. And after slipping back since January, the share price
seems absurdly cheap. The bank's earnings power is well over $4 a share, a
rate it should reach sometime next year. At the current $47 share price,
that's a price/earnings multiple of less than 12 for a stock with a 12
percent compound growth rate and a 2.8 percent dividend yield.

I'm less enthusiastic about Bank One. Consumer indebtedness has doubled
since 1992. So I can't help but wonder how quickly the bank's problem loans
will be taken care of. It's true that consumers will be getting some tax
relief and that recent mortgage refinancings have boosted disposable
income. But we all know that most of that money is going to be spent
instead of going to reduce household debt. As a result, I think Bank One
will be working through problem loans for a while -- and it's a more
expensive stock than many other bank issues.

=====================
Check out Michael's latest chat transcript discussing the markets, tech
stocks, financials, and more ...
http://www.money.com/money/chat/2001/010605.html
=====================

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