Recently, many analysts have viewed the second quarter results of Goldman, JP Morgan, and, remarkably, Citicorp and Bank of America as signaling that the banking industry has stabilized. However, a closer look at the Citi and BofA earnings highlight significant areas of concern for future performance. Similarly, many banks can expect their next six months to be considerably rougher than their already rocky first half, as at least four earnings landmines exist.

Not surprisingly, bad lending is chiefly responsible for the negative outlook. In addition, few banks have figured out a sustainable path to future growth.
 
Landmine One: Commercial Real Estate
While many banks appear stuck in a quicksand-like reliance on lending, continued reliance on traditional lending provides a very uncertain growth path.  Loan losses will likely rise in many different areas.

Of course, commercial real estate (CRE) is a central concern for banks. In many regions, office vacancy rates have risen to all-time highs, increasing the pressure on CRE borrowers. No near-term upturn should be expected, as small and mid-sized companies look to reduce facility costs, and building owners strain to make loan payments. In addition, the CRE loans made by some banks two-to-four years ago reflected their extremely positive (in retrospect delusional) outlook about regional economies.

Monday’s Wall Street Journal reported that CRE-related loan losses could reach $30 billion by year-end. Importantly, that article also states that in light of CRE performance, charge-offs have been insufficient and will likely increase (substantially for some banks) in the next few quarters. The article cites that “since the beginning of last year, the amount of charged-off commercial mortgages as a percentage of such debt outstanding has ranged from a high of 3.2% to as low as 0.3%.” While many view larger banks as being aggressive in timing losses and reserves, in fact   smaller banks, in particular, appear to be pushing off recognizing losses, perhaps due to their limited equity cushions.

Landmine Two: Multiple Choice
Consumer lending, C&I lending, small business lending, all seem to offer landmines to the industry with few, if any, “safe-haven” lending areas existing. Ironically, given the sub-prime disaster, residential mortgage refinancing has offered the industry one of its few areas of lending growth, as borrowers take advantage of lower interest rates.

Obviously, no bank should take a passive stance in the current environment, and the good banks we know are evaluating their portfolios, assessing current risks proactively, and trying to uncover problems before they explode. That said, in many cases (forgive the cliché) the horse is already out of the barn. As per the weekly bank closing announcements by the FDIC, some banks have literally destroyed themselves; many others have severely injured themselves, resulting in their focusing on defensive measures to survive. Many more appear unable or unwilling to take advantage of the much weaker competitive environment.

Landmine Three: The Death of Loyalty
Beyond the near-term credit problems, the industry has undercut its image and alienated much of its customer base. In recent months, I heard a D.C. banking lobbyist discuss how the banks were viewed very negatively by Congress versus the “white knights,” credit unions. We have also seen multiple surveys that point to the disenchantment of many consumers and small businesses with their banks. For every one media story of a bank sticking with its customer, there seem to be ten detailing the opposite.

Banks may find it increasingly difficult to convince customers of the value of one-stop shopping, since many customers feel they have been abandoned by their banks. This is not just a situation in which the big banks are the bad guys; many community banks have also been slow to step up. Our concern is that, given the CRE situation, many more will be unable to support their customer base.

Landmine Four: No Path to Growth
JP Morgan and Goldman Sachs did not generate big earnings from old-fashioned lending; they levered their capabilities in investment banking and capital markets. Other banks that we expect to do well such as Northern Trust and Commerce Bank (MO) operate with a strong emphasis on wealth management and payments, respectively.

However, relatively few banks have developed capabilities that emphasize non-lending expertise. Even worse, many seem paralyzed by the current crisis and unable to think beyond the next quarter or the next report they need to file. Of course, caution is understandable, but the elements that drive banking’s profit engine may be changing substantially and, perhaps, fundamentally. Frankly, too many bank executives seem unprepared for a new competitive dynamic even if they survive the near term.

Final Thoughts
These really are unprecedented times, times in which history may be less of a guide than it has ever been before. While it is becoming increasingly clear who the losers are in this cycle, it is much less clear who the winners will be. If much of the industry condemns itself to low growth and mediocre returns because of its inability to think beyond lending, consolidation will be faster and more dramatic than what analysts are currently predicting.