US CREDIT-US banks may gain near term, hold longer-term risk

By Karen Brettell

NEW YORK, Sept 28 (Reuters) - U.S. banks' bonds are likely
to continue their recent gains as improving prices in assets,
including risky mortgage loans, boost revenues and demand for
corporate debt remains strong.

Risks that banks take new losses to loans from commercial
real estate could weigh on their debt in the intermediate term,
however. A shift away from short-term funding sources to
longer-term debt could also push up debt yields.

U.S. bank bond spreads have rallied to an average spread of
around 300 basis points over U.S. Treasuries, from more than
500 basis points in May and more than 700 basis points last
December, according to Merrill Lynch Bank of America data.

"I think the debt rally will sustain itself because there's
lots of money sitting on the sidelines that's now coming back
into the market," said Ethan Heisler, analyst at Hexagon
Securities in New York.

"Fundamentals for the third quarter have also been
validating the general optimism being expressed in the market,"
he said.

Bank debt has been boosted by general appetite for
corporate bonds from investors diversifying away from equity
markets. Improving prices of credit assets also means that
banks are likely to benefit from recording the higher value of
risky debt on bank balance sheets.

"Over the past few quarters banks have generally had strong
earnings that were offset to a significant extent by credit
write downs," JPMorgan analysts said last week in a report. "As
the pace of these write downs declines, earnings and credit
metrics should improve sharply."

JPMorgan analyst Chris Flanagan estimates that U.S.,
European and Japanese banks are 72 percent of their way through
recording losses from mortgages and asset-backed derivatives,
after taking writedowns of $1.6 trillion. They are likely to
take an additional $560 billion, he said.

A number of negative factors are weighing on banks that
could see their debt underperform in the longer term, however.

LONGER-TERM RISKS

"We continue to believe that there are important weaknesses
remaining in the financial fundamentals of banks, particularly
with respect to their asset quality and funding profiles,"
analysts at Moody's Investors Service said in a report last
week.

Banks, which have benefited from inexpensive, short-term
funding, are increasingly under pressure to increase their
longer-term funding sources to protect against the type of
refinancing risk that helped bring down Lehman Brothers.

Government programs designed to help shore up banks with
cheap, government-subsidized funds are also beginning to wind
down.

"With the expiration of these programs, and in absence of
any new program to support the issuance of long-term debt,
banks will be challenged to reconstruct their funding profiles
in a cost effective way," Moody's said.

Moody's also believes that banks have not yet provisioned
for approximately $235 billion in new writedowns it expects
banks to take by the end of 2010.

"We expect earnings to be insufficient to offset these
losses during that period, resulting in many banks being
unprofitable," Moody's said.

And this is likely to increase the cost of bank's long-term
debt, they said.

"This may, in fact, be the most vulnerable feature of the
U.S. banking sector right now," Moody's said.
(Editing by Kenneth Barry)