Bank shares sink to 1996 levels on loss fears

NEW YORK (Reuters) - U.S. bank shares fell to their lowest level since 1996 on fears of greater credit losses for an already battered sector.

The 24-member KBW Bank Index .BKX, consisting mainly of the biggest U.S. banks, fell as much as 7 percent on Tuesday.

They closed down 3.1 percent, recovering some losses after Federal Reserve Chairman Ben Bernanke affirmed that helping financial markets return to normal functioning was a top priority for the central bank.

Among large U.S. banking companies, shares of Citigroup Inc (C.N) fell 4.3 percent, Bank of America Corp (BAC.N) slid 8.1 percent, Wachovia Corp WB.N fell 7.7 percent, and even JPMorgan Chase & Co (JPM.N), considered among the healthiest big banks, dipped 2.1 percent.

"Skepticism remains related to all the credit issues," said Alan Gayle, senior investment strategist at Trusco Capital Management in Atlanta.

More negative news came from Minneapolis-based U.S. Bancorp (USB.N), which said credit losses contributed to a surprisingly large 18 percent drop in second-quarter profit.

The sixth-largest U.S. bank tripled the sum it set aside for bad loans, largely because of the declining housing market, amid what Chief Executive Richard Davis called a "challenging and stressful" economic environment.

Its shares closed down 2.7 percent, despite enjoying a brief rally after Davis said he intended to raise the bank's dividend.

"Everyone was broadsided as to how quickly house prices eroded this year," Oppenheimer & Co analyst Meredith Whitney said on a conference call. She said the idea the year-long credit crisis is close to over is "factually not possible."

In his semi-annual monetary policy report to Congress, Bernanke said rising energy costs, tight credit and a further contraction in housing are significant downside risks to the economy, even as inflation fears intensify.

He also said consumers and businesses are likely to be cautious with spending for the rest of the year.

This could result in lower borrowing needs and higher competition among lenders for business, crimping margins and profitability.

Bernanke nevertheless said that despite the "considerable stress" in financial markets, the banking sector remained well-capitalized.

Whitney also downgraded Wachovia Corp to "underperform" from "perform," saying shareholders of the fourth-largest U.S. bank face a "bleak" outlook as losses from adjustable-rate mortgages climb.

"Expenses simply cannot come down fast enough thus seriously jeopardizing Wachovia's ability to grow earnings," she wrote.

Meanwhile, the slide in shares of Fannie Mae (FNM.N) and Freddie Mac (FRE.N) deepened, despite Sunday's plan orchestrated by U.S. Treasury Secretary Henry Paulson to extend more credit or buy stakes in the mortgage finance companies.

Paulson said on Tuesday the government plan was designed as a backstop, and that the government had no intention of investing taxpayer money in the companies now.

Fannie shares closed Tuesday down 27.3 percent, and have fallen 31 percent this week. Freddie shares fell 26 percent on Tuesday, and are down 32.1 percent this week.

Investors also have been on edge by speculating on which banks might be next to fail after federal regulators on Friday seized IndyMac Bancorp Inc IMB.N, the nation's ninth-largest mortgage lender in 2007 and one of its largest savings and loans.

John Bovenzi, the FDIC official running what is now known as IndyMac Federal Bank, on Monday said he expects more small banks to fail in the current credit downturn. IndyMac was the fifth banking company this year to fail.

(Additional reporting by Jennifer Ablan, Walter Brandimarte, Ellen Freilich and Steven C. Johnson in New York, and Mark Felsenthal and Emily Kaiser in Washington, D.C.; Editing by Carol Bishopric)