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Banks are Gradually Healing

Wells Fargo kicked off earnings season last week with a preannouncement shocker – a $3 billion profit, double what analysts had forecast. Details on credit quality and trends were lacking and bad loan reserve levels were smaller than expected. Earnings results were driven by mortgage volume, which was up 40% overall, with a 64% increase in mortgage refinancings. Wells Fargo is the most active bank in the mortgage market so it is benefiting from the lower rates more than other banks. Clearly, both banks and consumers are benefiting from the current low interest rates in mortgage and auto loans, and bank earnings are showing signs of turning the corner.

Why the focus on these large banks and why are they so important to the financial system? The top 20 banks account for more than 80% of the deposits in the banking system so their health is critical to the economy. Credit is to the economy what oil is to your car, it is necessary to keep the economy functioning and running smoothly. The wisdom of the TARP program and direct government support for banks will be debated for years, but we will soon know what the remaining problems are, and we can be reasonably confident the rest of the banking system will eventually recover and return to profitability in the coming years. Is this a good time to buy banks? Perhaps, but we think the recent rally may be short-lived. High unemployment levels will lead to more loan and credit card charge-offs for months, and banks will need time to replenish their reserves, payback the government TARP funds, and rebuild their capital. Banks are gradually healing.

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