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US Banking Industry Faces Uncertainty in 2007 (November 8, 2006)

Location: New York
Author: Ellen J. Silverman
Date: Wednesday, November 8, 2006

Standard & Poor's maintained "a modest positive bias" in its 2007 rating outlook for the U.S. banking industry, amid expectations that profitability will remain "healthy" next year. But S&P said in its report that the industry faces uncertainty revolving around the actions of the Federal Reserve.

Overall, S&P said it expects a stable outlook for most U.S. banks in 2007, but "we maintain a modest positive bias in our rating outlook as we anticipate some financial institutions to continue to outperform their peers". On Wednesday, S&P raised its rating outlook to positive for the largest banks in the U.S.: Citigroup, Bank of America, JP Morgan Chase, U.S. Bancorp and Wells Fargo. The banks' high profitability, diversification and improvements in risk-management should shield them from cyclical downturns, S&P said.

Overall "the wild card in our expectations remains whether the Fed can successfully engineer a soft landing of the economy." Specifically, a fast-falling housing market risks boosting defaults on debt repayments and forces banks to write off bad loans and/or lift their reserves for such loans. The credit environment has remained "pristine" in recent years "but all good things must come to an end" and S&P expects credit losses will rise to "more normal" levels in 2007. While S&P expects the majority of banks will fare well because of the above-mentioned improvements over the past decade, it said that its positive ratings "have not factored in an adverse credit scenario that could result from a hard economic landing." Already banks face strong headwinds from the current interest-rate environment.

While the Fed lifted short-term rates through the first half of 2006, long-term rates have remained mostly flat and actually fell in the third quarter and are pressuring banks' margins. Banks make money by borrowing at what are normally cheaper short-term interest rates to lend at normally richer long-term rates, with the profit making up their net interest margin. Many banks have adjusted their balance sheets to the rate environment by trying to cheapen their sources of funding and by selling non-performing long-term assets. Relief for bank margins could come if the Fed cuts interest rates to stave off an economic slowdown and if long-term market rates start rising to reflect those expectations.

"How management teams optimize their banks' balance sheets as consensus expectations shift to a soft economic landing scenario next year remains the most critical issue," that could influence whether S&P lifts its ratings on some banks in the near future, the report said. But looking farther into 2007, credit quality will remain the key determinant. "Historically, margin shrinkage has been a manageable pain with which banks deal on a regular basis," S&P said. "Credit explosions, on the other hand, have dealt the death blow to some financial institutions in the past."

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