Foreclosures dominate bank earnings season

JUST before third-quarter earnings season kicked off in the US, JP Morgan released a research note on the US banking sector calling banking stocks “attractively valued”. Pointing to improved credit conditions this year, the note was cautiously upbeat, revising near-term estimates upwards. But there was one word missing from the note: foreclosures.

In the past couple of weeks, the foreclosures (repossessions, in UK terms) scandal has earned its own “-gate” suffix, with some suggesting that a worst-case scenario could renew the financial crisis. Banks are in trouble for allegedly trying to speed up the process of foreclosing and selling on homes by ramming them through “foreclosure mills” – firms where unqualified, low-level employees supposedly rubber-stamped hundreds of vital court documents.

Bank shares have sunk across the board since attorney generals in all 50 states opened a joint inquiry into the matter. Bank of America has fallen 3 per cent, Citigroup 6.8 per cent, Wells Fargo 9.2 per cent and JP Morgan Chase 8 per cent. This is despite earnings per share for both JP Morgan and Citi coming in at the higher end of analysts’ forecasts, at $1.01 and $0.09 respectively (BoA reports today and Wells Fargo tomorrow).

The problem is that the markets are fixated on the foreclosures issue – with good reason. Currently, nearly a quarter of US home sales involve repossessed houses and many of these have now been paused: BoA has suspended foreclosure sales in all 50 states while JP Morgan has put 116,000 on hold. And this will be an ongoing headache, potentially with multiple class-action lawsuits to resolve.

Of course, if the foreclosures problem turns out to be relatively limited, stocks could rebound and traders willing to make a risky bet could go long now. But a more sensible approach might be to look at banks not directly affected by the issue, but which have been dragged down by it. S&P Equity Research’s Erik Oja is positive on regional banks such as Huntingdon Bancshares, Comerica and Fifth Third Bancorp, which contract-for-difference (CFD) traders can bet on from the UK. These banks, like their national counterparts, should see credit quality improvement and reduced loan loss reserve ratios (see chart), but be less tainted by the crisis.

Even so, it will pay to keep a keen eye on foreclosures not just for their effect on banking stocks, but more broadly. Oja points out: “If the foreclosures halt continues, that will have a serious impact on existing home sales, which will affect everything from growth to credit quality.” The risk for traders of bank stocks is that there are further hangovers from the financial crisis still to emerge.