Europe's Bank Storms Headed to U.S.

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NEW YORK (TheStreet) -- U.S. big bank investors may want to use unusually negative comments by European bank conglomerate CEO's in recent earnings as a reason to reassess the risks to financial institutions on this side of the Atlantic - even as first quarter earnings at JPMorgan JPM , Bank of America BAC , Citigroup C , Goldman Sachs GS and especially Morgan Stanley MS reflected a revival in some key businesses.

On Thursday, Deutsche Bank DB , Europe's largest bank by assets, and Barclays BCS , Britain's second biggest lender reported improving profits that were below year-ago-levels, mirroring the first quarter results of most U.S. investment banks. But the commentary of both banks' CEOs on those earnings warrants a focus by investors in U.S. banks - especially those who aren't ready to call a 2012 sector rally a recovery.
As April ends, Morgan Stanley could be a watershed on a 2012 bank sector rally

"Financial markets remain cautious -- as we have seen in April, with investor risk appetite markedly lower," said Deutsche Bank chief executive Josef Ackermann in a letter to shareholders. "Investors, particularly private investors, remained wary after the market turmoil of last year."

Barclays chief executive Robert Diamond mirrored concerns of an April slowdown, in commentary that seemed to refute some of the optimism that spread over the financial sector to start the year. "It was not a robust first quarter," said Diamond in a media call with reporters, according to Bloomberg. "It was only robust compared with the third or fourth. I think most people would say April was a bit sluggish compared to the first three months."

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While falling loan losses, increased lending and a recovery in debt trading were a boost to U.S. bank earnings in the first quarter, and broader corporate earnings and recovering markets augur well for the overall U.S. economy, problems persist in Europe and its struggling banking system. Late on Thursday, Standard & Poor's downgraded the rating of Spain from A to BBB+, citing weakness in the country's banks. Overall, bond yields in the eurozone are rising, once more, after they collapsed on the heels of European Central Bank support in November, which bolstered global markets.

Now some indicators are showing early warning signs that fear may once again preoccupy U.S. bank investors. "Investors are repricing risk at some large U.S. banks following earnings reports," notes Standard & Poor's credit analyst Peter Rigby in a Thursday report. After bond spreads peaked for the nations four largest banks in November as a debt crisis escalated to a near boiling point across the Atlantic, Rigby says that, "there is evidence that investors may be repricing risk."

Though U.S. banks have rallied strongly in 2012, with Bank of America posting a near 50% year-to-date gain and most peers up roughly 30%, the shares of industry giants have tailed off in the past month even as they escaped Federal Reserve stress tests, boosted dividends and reported generally strong earnings.

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As April draws to a close, the shares the five largest U.S. banks are off by between 8% and 18%. Meanwhile, credit spreads on major U.S. financial institutions remain between 30 to 60 basis points higher than 2011 levels, according to S&P calculations.

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If investors in bank bonds and stocks are repricing risk, the obvious question is what are those risks? For Rigby of S&P, they're mostly lingering issues that may be hidden in plain sight once again, as optimism builds. "The difference in these banks' spreads is not just that negative outlooks may be pushing them wider, it's the reasons we assigned the negative outlooks," notes Ribgy.

"BofA has significant exposure to mortgage-related litigation and to the housing markets. Although some of this risk has stabilized, potentially sizable and volatile downside risks remain. For Citi, our negative outlook was based on our assessment that weakening economic conditions may hinder its ability to divest large assets in Citi Holdings. Citi is trying to shed $55 billion to $80 billion in assets, including further reducing its holdings in North American mortgages. Repercussions from Europe's financial problems also could result in a downgrade. Our negative outlook on Goldman reflects the potential effects of the European sovereign-debt crisis and the attendant risks to Goldman's funding and liquidity."

If a bad April in Europe reignited lingering concerns regarding U.S. banks, it wouldn't be the first case of investor amnesia, after previous false starts in the financial sector.

Still, it's Morgan Stanley, which reported the strongest earnings of any large bank and wasn't included in Ribgy's analysis, that may be the industry's watershed as May approaches. The nation's sixth largest bank by assets is poised to take the worst hit from a prospective the string of ratings downgrades by Moody's that could come in May, reducing bank ratings by up to three notches. A March report from Nomura analyst Glenn Schorr noted that the cuts would put the sector's average debt rating at "baa," a low rung of investment grade.

Schorr calculated in his March 19 note that on a downgrade, large bank stocks could drop between 2% to 5%. "Though Moody's ratings review has been well telegraphed and investors have typically dismissed the credit ratings impact to bank stock prices, we think headline risk for the stocks remains."

Moody's Investor Service is reviewing the ratings of 17 of the largest U.S. banks, with the exception of Wells Fargo WFC , for possible ratings downgrades that better reflect risks such as dealing in capital markets. Such downgrades for Morgan Stanley and its competitors could hurt relationships with key trading partners like Blackrock BLK . In first quarter earnings, the firms' chief executive Larry Fink said that he would diversify from some trading partners if they were downgraded.

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In a Thursday research note, Bernstein bank analyst and former Lehman Brothers CFO Brad Hintz said that those possibly imminent cuts are weighing on bank stocks and Morgan Stanley, in particular. "At this point Bernstein believes equity investors should assume this potential downgrade is likely to occur. The worst case will result in the restructuring of the ratings of JPM to A2, of GS to A3, of MS, C and BAC to Baa2."

For Morgan Stanley, a three notch cut could lead to $5 billion in collateral costs to Morgan Stanley, while chipping up to 30% from the company's bumper fixed income earnings. Still, even a worst case outcome may not be a crucible for Morgan Stanley or other U.S. banks. "Bernstein's bottom line conclusion is that a worst case three notch downgrade is not an end of the world scenario for MS. But the potential downgrade makes it more difficult for MS' fixed income business to sustainably outperform," adds Hintz.

Interestingly, in first quarter earnings, it was Morgan Stanley MS , an expected laggard, which provided the biggest beat among the large U.S. investment banks as Wall Street's first quarter earnings season drew to a close last Thursday.

Morgan Stanley's beat came on expectations that its earnings would fall behind Goldman Sachs GS and JPMorgan Chase JPM , who reported slightly better than expected results earlier in April, buoyed by a strong quarter-over-quarter recovery in their trading and fixed income related divisions.

Investors interested in large U.S. banks should take April caution by CEO's in Europe as cause to revisit the risks that remain in the sector before calling a 2012 rally a recovery.

For more on investment banking earnings, see why JPMorgan is the Apple of the banking sector.

-- Written by Antoine Gara in New York.

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