4 Bank Stocks Provoking Promise and Pessimism

We've been waiting for the banking sector to turn around for two years now. But even though many banks are trading for a fraction of book value, I caution you against jumping into the sector just yet. It's simply too early to say when, or if, it will recover.

The good, the bad, and the ugly
The four largest banks increased their net incomes across the board last quarter compared with the same quarter a year ago. Bank of America (NYSE: BAC) led the way with an increase of $13.5 billion, though much of that gain can be attributed to a large one-time loss in the third quarter of 2010 and a recent $3.6 billion gain from the sale of its interest in China Construction Bank.

Sources: Third-quarter earnings releases and financial supplements. Revenue figures are net of interest expense.

Although an increase in net income is good, you should avoid reading too much into it. As we saw with Bank of America, banks often distort their net incomes with accounting maneuvers. For example, with the exception of Wells Fargo, each of these banks recorded unrealized gains of nearly $2 billion related to decreases in the price of their own debt. If this surprises you, you're not alone, as the head of Morgan Stanley (NYSE: MS) admitted that a similar $3.4 billion adjustment at his firm was a "bizarre accounting anomaly."

Among other things, the Federal Reserve's decision to lower long-term interest rates is straining banks' collective earnings. A bank's profit comes in large part from the difference between the low short-term interest rate it pays depositors to borrow their money and the higher long-term interest rate it receives from lending that same money back out -- what's known as the interest-rate spread. This spread decreased an average of 26 basis points from a year ago.

Sources: Third-quarter earnings releases and financial supplements.

On the positive front, banks have made significant progress working through the bad loans on their balance sheets. According to my calculations, these banks have decreased their loan losses by approximately 70% from the height of the financial crisis. And although they still have a way to go before returning to pre-crisis levels, we can begin to see the light at the end of the tunnel.

Sources: Third-quarter earnings releases and financial supplements.

Finally, and similarly on a positive note, three out of these four banks increased their tier 1 capital ratios. This ratio compares a bank's core capital -- namely, its retained earnings and equity from common stock -- with a risk-weighted measure of its loans. I like to see ratios around 10%, and most of these banks are approaching that target. One has already exceeded it.

Sources: Third-quarter earnings releases and financial supplements.

Foolish bottom line
There are reasons for investors to be both optimistic and pessimistic about the current state of America's largest banks. Although they've made progress cleaning up their balance sheets, their near- and medium-term profitability is questionable given the direction of interest rates and the threat of contagion from Europe.

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