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• BAC 71% Rate It
• C 73% Rate It
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• JPM 73% Rate It
• MS 71% Rate It

U.S. bank earnings for the full year and fourth quarter of 2011 reflected all that was good about the US economy, all that was bad about the global capital markets, and much that was punitive about the regulatory arena. Loan quality improved and nascent growth could be detected, but trading revenues were down, and banks staggered under $35 billion of legal charges related to mortgage loans sold and the loss of about $7 billion in revenues due to regulatory changes. As the year ended, major questions about how those three issues would be resolved still hung in the air, and promise to bedevil 2012 as well. All that leads analysts to ask, what of what we saw in 2011 will be the new normal? I believe that that is too pessimistic a view.

*excludes gains on sale, other non-recurring items, and gains/losses on own debt but includes mortgage-related special charges

The good news

Tentative US economic growth manifested itself in a pick-up in commercial lending activity for small and medium sized businesses in the second half of the year. Syndicated lending activity was strong as well, and US banks profited from the retreat of European counterparts to pick up business there. As a result, commercial loans grew 5.5% for the year.

Loan losses except for first and second residential mortgages are now at or better than normal levels for a stable economy. Lower loan losses, as well as reserve reversals, have allowed provisions to fall by two-thirds from 2009. The corporate sector is healthy. Credit card portfolios have been cleaned out of the weaker borrowers, so that card charge-off rates are only about 4.5%, a level not seen for about 15 years. Provisions remained below the level of charge-offs during the year but crept upwards to finish at 92% by the first quarter. Reserves were therefore depleted as a percentage of loans but not in terms of their coverage of annual losses. Provision expenses will likely level out in 2012 as loss rates edge down slightly but reserve reversals diminish.

By 2013, provisions could start to climb again. Much will depend on the pace of mortgage losses however. They remain at very elevated levels; even though some barely perceptible improvement in loss rates was visible in 2011, once foreclosures resume, they could rise again, and take a few years to work through.

Based on these trends, the traditional commercial banks, especially those that were not large mortgage lenders, were solidly on the come-back trail. Persistent low interest rates are the remaining obstacle to achieving normalized profits. Net interest margins have been in steady decline for three years, but appeared to stabilize, or even rise a few basis points in the fourth quarter versus the third.

A stronger economy with rising rates would boost margins because of the vast amount of "free funds" (e.g. checking deposits, common equity) on bank balance sheets that could then earn higher interest.

Investment banking reflects volatile and uncertain capital markets

For the largest six banks, all of whom have investment banking or mortgage operations, or both, the story is more troubling. Deep uncertainty about whether a disorderly unwinding of the European Union or some of its members could precipitate another financial meltdown sidelined many participants. Client revenues in trading fell 20% for the year, especially in the second half:

The fourth quarter was pretty flat with the third if we consider that Citigroup ( C ) had a $900 million negative swing factor from the hedges it maintains on its loan portfolio, which GAAP rules require to be recorded on the trading income line rather than netted against loan portfolio values. The fixed income desks were the primary culprits in the weak performance, while equity trading was relatively flat for the year.

Fee income from advisory and underwriting followed the same trajectory although they were down only 7% for the year. M&A and advisory revenues were up but volatile markets wreaked havoc with IPO's so equity underwriting was weak.

Worthy of note is that certain banks have held up better in this environment on both aspects of investment banking. JPMorgan ( JPM ) and Morgan Stanley ( MS ) saw less erosion of trading income over the past two years, while Citigroup and Goldman Sachs ( GS ) suffered a greater decline in investment banking fees than did their peers.

Could this lower level of trading profits be a sign of structural changes in the markets rather than a cyclical funk? The justifications for a cyclical phenomenon are abundant:

• Market volatility and the very real potential for a very uncomfortable outcome of events in Europe, both from an economic growth perspective and a financial market stability perspective have investors sidelined.
• A slow economy dampens investment and therefore capital raising.
• Spread widening in the debt markets is very real and would naturally have caused losses on inventory
• The Volcker rule is not yet in effect. Although banks have mostly disposed of their purely proprietary operations, these had never made much in earnings so are unlikely to be responsible.
• Uncertainty over regulatory treatments of various instruments, including derivatives, may be deterrents but only temporarily, until there is clarity
• Mortgage related activity is cyclically low. This had accounted for a large portion of capital markets activity

The case for a structural shift is that structured credit (and related credit derivatives) used to be a major source of revenues pre-2007. It may never return to its full glory. That factor did not change between the second and third quarters of 2011, when trading income dropped off precipitously, so it could not have been the cause.

The important issue to watch, however, is the final form of the Volcker rule. If it is adopted in such a form that it hampers market-making activities and bank's ability to provide liquidity to markets, it could have a long-term deleterious effect on the economy, on capital markets and, by implication, on trading profits and indeed on the whole of investment banking business for US banks

Mortgage banking remains an albatross

While mortgage refinancing activity appeared to revive in the latter part of the year, the four mega-mortgage banks struggled under the huge weight of provisions for compensating the GSE's and investors for alleged misrepresentations of the quality of loans sold into securitization vehicles during the mortgage boom. Charges for representations and warranties, litigation and other related issues totaled $35 billion for 2011, on top of a like amount taken over the three prior years. Bank of America ( BAC ) has been taking the largest hits, paying for the exceptionally poor quality of loans originated by the Countrywide unit it acquired in 2007.

More charges are on the way. The joint suits being brought by the Attorneys General of most of the states, could be settled over the next couple of months. If the settlement is $25-28 billion for the top five lenders, as rumored, litigation reserves of only about $22 billion at these four banks will not be sufficient (see my third quarter overview ). While hopefully the settlement will include indemnification from some of the other related liabilities, other litigation will likely continue for several years.

Other mortgage related costs are also very high. Processing delinquent mortgage loans especially in light of new regulations, as well as astronomical losses on mortgage loans in their on-balance sheet loans create a significant drag on earnings for these banks.

Strategic Decisions On Hold

Uncertainty about the ultimate regulatory standards has left certain strategic decisions on hold:

• Dividends and share buybacks . Results regulatory stress tests due in March should not yield any nasty surprises but will provide insight into just how much banks will be permitted to raise dividends or repurchase stock. In addition, finalization of the Basel III rules and particularly the amount of surplus the "systemically important" banks will have to hold above the 7% of Tier 1 common equity.
• Disinvestments in investment banking . The Volker Rule on proprietary trading activities is very contentious. Under certain proposals it could hamper market making activities and have a very significant effect on trading revenues. New rules on clearing and exchange trading of derivatives could affect the derivatives business. In addition, if capital markets do not recover in the course of the year, meaning that if the European situation is not clarified, staff downsizing could be required.
• Potential sales of businesses. The penalties for being large, both in terms of additional capital charges and in terms of additional regulatory oversight could prompt some to break up their banks. Also Basel 2.5 potentially assigns risk weights to certain activities that banks deem will preclude earning a reasonable rate of return and so will seek to divest. So far, banks have identified correlation trading, certain structured credit activities, private equity and hedge fund ownership, and mortgage servicing assets as areas for wind-down or divestiture.

We can expect to see such decisions come down starting mid-year in 2012.

Meanwhile, the falloff in revenues has already resulted in belt-tightening and staff reductions. Operating expense ratios (noninterest expenses as a percentage of revenues) are at untenable levels even if we strip out all of the litigation and reps and warranties expenses.

Banks have reacted by announcing various expense reduction programs whose impact will mostly kick in in 2012. These have included layoffs and various re-engineering efficiencies. These are merely in response to what is clear to management about the state of affairs to date, but do not reflect any of the important strategic decisions yet to be taken, as mentioned above. As those firm up, we can expect more cutting.

These ratios may not return to previous levels. Some revenues have been lost as a result of legislation: over $7 billion in overdraft fees, and credit and debit card fees. It is an open question whether they can be replaced. Heavy expenses to service delinquent mortgages are here for the medium term at least. And increased compliance costs for new regulations are here to stay. Efficient operations and the ability to rein in bonuses may become a distinguishing feature of successful banks.

Capital Standards May Restrict Dividends and Buybacks

The focus is shifting to the new Basel III capital standards. Even though they will not be fully in effect until 2019, the competitive arena may force banks to reach the fully phased in rules much earlier, perhaps a year from now. All but Bank of America among the largest eight banks in the US would be fully compliant with the base 7% of Tier 1 common to risk weighted assets requirement today. Bank of America is probably around 6.3%; others fall between 7.4% and 8.2%, with Citigroup at the high end. However, systemically important banks will need a buffer over that, perhaps as high as 2.5%. To reach the full 9.5%, these banks will need an additional $146 billion of retained earnings over the next couple of years; about $60 billion of that would be for Bank of America, which represents a 50% increase to current capital. For all banks, such numbers would preclude dividend increases. Bank of America succeeded in increasing its Tier 1 common ratio by 1.2 percentage points in the fourth quarter through asset sales that produced gains while at the same time reducing risk weighted assets. However, it has completed most of the slated sales so further increases will be slower. It will take several years to robust retained earnings to reach the goal. If, on the other hand, the requirement is only 8.5%, the capital shortfall is only $14 billion, a much more manageable number that will permit more payments to shareholders.

Prognosis for 2012

This year could prove to be the one in which many of the questions overhanging the industry will be clarified: regulation, certain critical litigation, Eurozone survival. That will clear the way for some strategic decisions. The housing markets will likely still be struggling, producing a long tail of high servicing costs, high write-off levels and a battery of litigation expenses, albeit at a lower level after the attorney's general settlement occurs.

However, in an economy that is growing, with at least a stabilization in housing markets, both revenues and profit margins have a chance of expanding. Investment banking income should improve, cost cutting efforts should kick in, and net interest margins should expand. Banks should be able to returns to a substantially higher level of profits, if not the heyday pre-crisis levels. The new normal will begin to shine through (see Is There A Future For Bank Earnings? ).

Disclosure: I am long [[C]], [[MS]], [[JPM]], [[WFC]].

See also Is Frontier Communications A Long-Lerm Buy? on seekingalpha.com

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