By Maria Aspan and Joe Rauch
NEW YORK/CHARLOTTE, North Carolina (Reuters) - One of the U.S. banking industry's main methods of pumping up profits in recent quarters may be nearing its limits, and third-quarter results are expected to be lackluster as a result.
JPMorgan Chase & Co <JPM.N> is slated to be the first big bank to report third-quarter results. On Wednesday, analysts expect the second-largest U.S. bank to report an anemic 1.3 percent increase in profits over the same period last year.
That may set the tone for a tough earnings season. For the last two quarters, U.S. banks have boosted earnings by setting aside less money to cover loan losses -- less than even the bad loans they wrote off during the quarter.
Setting aside less money made sense when credit losses seemed to be stabilizing. But with economic growth slowing, it is not clear whether it makes sense to reduce loan loss reserves, or earnings set aside to cover losses.
"You can only go to that well so much. You can only take so much of it, and then it's not there," said Matt McCormick, a portfolio manager and banking analyst with Bahl & Gaynor.
With loan demand weak and lending profit margins narrowing, banks have few other sources of profit growth compared with the second quarter, analysts said.
Bank of America Corp <BAC.N> and Citigroup <C.N> are both expected to post lower profits for the third quarter compared with the second, although they may outpace the extremely weak levels of a year before.
"It was a pretty dismal quarter," said Michael Nix, principal at Greenwood Capital Associates.
Nix, who owns Bank of America shares as part of his firm's $850 million of assets under management, said he is "pretty much holding right now on the banks. We're going to see some pretty significant headwinds."
According to StarMine, the analysts with the best track records are more pessimistic about results for Bank of America and Citigroup than the consensus figures.
CHEAP, BUT FOR A REASON
Bank stocks are relatively cheap, with most trading at less than their book values, analysts said. Historically, big banks have traded at closer to twice their book value.
But these stocks are only "undervalued on what we know today, and that's the difficult thing," Greenwood's Nix said. "The problem is, what will that look like down the road, either through specific company efforts (to sell off units) or through regulatory impact?"
Citigroup is shedding assets it considers separate from its main businesses, leaving investors uncertain about its earnings power once it finishes slimming down, Nix said.
Investors are also awaiting more clarity on the ultimate impact of the sweeping Dodd-Frank financial reform law, which will restrict banks' profits from debit card processing and limit their proprietary trading. Bank of America warned in July that it could lose some $2 billion of its annual debit processing revenue under the law.
JPMorgan Chase could also be hurt by Dodd-Frank over the long term, particularly by the law's provisions that move much derivatives trading to exchanges.
U.S. regulators are also investigating banks' foreclosure practices amid rising public outrage over some banks' faulty paperwork, making investors brace for potential new restrictions on mortgage lending.
U.S. banks set aside $40.3 billion in the second quarter to cover loan losses, the lowest provision level since the first quarter of 2008, according to U.S. Federal Deposit Insurance Corp data.
The lower level of reserves contributed, in part, to the highest net income posted by U.S. banks in two years, topping $18 billion last quarter, according to FDIC data.
Large banks have recently used reserve releases to help beat market expectations, but investors have reacted with skepticism.
Shares of Bank of America Corp <BAC.N>, the largest U.S. bank by assets, and Citigroup Inc <C.N> slumped when they reported second-quarter earnings in July. Since then, Bank of America shares have lost another 4 percent, while Citigroup has regained nearly 7 percent.
Both banks beat expectations last quarter, but about 40 percent of their profits were due to reserve releases, as each bank released about $1.2 billion net of taxes during the quarter.
Investors know that reserve releases cannot continue indefinitely, and seem to be valuing those banks accordingly.
"If you're a little too aggressive in drawing down reserves, you're not going to get credit for it. People just view that as low-quality earnings," said Scott Siefers, a managing director at Sandler O'Neill and Partners.
Investors are more "laser-focused" on signs of revenue growth, Siefers said.
But investment banking revenues are expected to slump for the third quarter due to low trading and underwriting volumes. And for now, at least, it is not clear where loan growth will come from for most banks. Consumers have started repaying their bills, but are reluctant to take on more debt as unemployment remains near 10 percent and economic growth is weak.
Total outstanding U.S. consumer loans, excluding real estate, fell to $2.4 trillion in August, their lowest level since 2006, according to the Federal Reserve.
To be sure, the news for banks may not be universally gloomy. SunTrust Banks Inc <STI.N>, for example, expects to post its first profit in seven quarters, Chief Financial Officer Mark Chancy told investors at the Barclays Global Financial Services Conference in September.
The Atlanta-based bank is the largest left in the U.S. government's Troubled Asset Relief Program.
But analysts cautioned that results in the sector are unlikely to leave investors cheery.
"Third-quarter earnings are going to feel about like kissing your sister," said Jeff Davis, bank analyst with Guggenheim Securities. "Outwardly, it might look okay, but how strong is credit really?"
(Reporting by Maria Aspan and Joe Rauch, editing by Gerald E. McCormick)