Analysis: U.S. bank investors may be waiting for Godot

A trader works on the floor of the New York Stock Exchange as the Federal Reserve's decision to leave interest rates untouched between zero and 0.25 percent is announced, January 26, 2011.

NEW YORK (Reuters) - U.S. bank investors hope rising interest rates will lift profits next year, but that hope may be misplaced.

The windfall scenarios are plausible enough: the Federal Reserve raises short-term rates, and the floating-rate loans that banks have made start paying higher interest. Meanwhile, rates that banks pay on deposits, which for most banks are the main source of funding, likely would not rise much at all.

The upshot is wider profit margins on loans, before credit costs, and a boost to earnings that could be substantial.

Marty Mosby, an analyst at Guggenheim Securities, thinks profits at the banks he covers could rise 22 percent next year -- excluding money set aside to cover bad loans -- in large part because of rising rates.

Among the winners could be SVB Financial Group, parent of Silicon Valley Bank. The Santa Clara, California, bank estimated in February that a 1 percentage point increase in short-term interest rates would boost earnings by more than 25 percent.

"These guys are a poster child for banks that will benefit from rising rates," said Thane Bublitz, who researches bank investments for Thrivent Financial for Lutherans in Appleton, Wisconsin.

Thrivent owns SVB shares and has been favoring bank stocks expected to perform well in a rising rate environment. Other investors are evidently doing the same. An index of financial stocks that would benefit from a contracting money supply has performed better than a broader group of bank shares, according to brokerage Keefe, Bruyette & Woods.

Wall Street analysts have been building forecasts for higher rates into their 2012 earnings forecasts, which has contributed to higher average profit estimates for banks like SVB, People's United Financial Inc and Zions Bancorp. Average estimates for the three banks have risen more than 7 percent since January.

The only problem is, the chances of a rate increase next year seem to be declining. At the beginning of the year, futures contacts based on Fed funds rates were pricing in a rate increase for January 2012.

But with renewed concerns about economic growth weakening in the second half of the year, traders have pushed those predictions further out. Futures contract prices now show about a 50-50 chance for a March 2012 rate hike, and about a 72 percent chance of a rate rise the following month.

The U.S. Federal Reserve recently cut its economic growth forecast for 2011, citing weaker-than-expected expansion in the first three months of the year.

The end of quantitative easing, set for June, has some investors anticipating rates will rise sooner rather than later. But fiscal stimulus is declining amid budget concerns, and fund manager Jeffrey Gundlach, chief executive of Doubleline Capital, argues that the end of quantitative easing will reduce inflation fears because the policy itself was inflationary. Easing inflation fears would allow rates to stay low for longer.

SHRINKING BALANCE SHEETS

Historically, said KBW's director of research, Fred Cannon, the Fed has kept money cheap until people and businesses borrow more, and that has not yet happened. "Loans at banks are continuing to shrink," Cannon said. "We have a ways to go before short-term rates start to go up."

A Fed survey of more than 75 banks, released May 2, showed demand for credit card loans was essentially unchanged in the first quarter, despite many banks having eased terms. Demand for residential mortgages declined.

Loan demand in some areas, including lending to companies, seems to be picking up. But consumers seem to be reducing their debt loads at a faster pace than companies are taking on new debt, and the net result for many banks is shrinking loan books.

With weak loan demand, higher rates may be one of the few possibilities banks have to boost profits, but rates are not likely to rise until loan demand increases. "It is a bit of a bad box the banks are in," said Cannon. "They are kind of stuck."

Banks have been boosting their earnings recently through setting aside less money to cover credit losses, or by dipping into funds previously set aside. Neither action is a sustainable path to growth.

This may explain why shares of banks that benefit most from rising rates are performing worse than the broader stock market, even if they perform better than other banks.

Still, there are pockets of firming loan demand from businesses, and this is keeping some bank investors at the ready to buy more, said Guggenheim's Mosby. He believes the Fed will start raising rates early next year and will signal the move in advance by dropping the words "extended period" from its statements describing how long it expects the economy to need its help. The signal could come as early as July and give the stocks a sudden surge, he said.

"You will need to be jumping on them right when that happens," he said. "That's when that basket of rate-sensitive banks will really start to go up." Until then, Mosby said, "there's still doubt."

(Reporting by David Henry, additional reporting by Jennifer Ablan, Editing by Dan Wilchins; editing by John Wallace)