CALIFORNIA'S CHANGING BANKING SCENE : Banks' Earnings Bode Well

Having confounded the doomsayers who thought California's deep recession would exact a much more painful toll, the state's major banks and S&Ls; are rolling in black ink again.

In a flurry of second-quarter earnings announcements Tuesday, Wells Fargo & Co., First Interstate Bancorp and H.F. Ahmanson & Co. all reported strong year-over-year gains.

The numbers are important for more than just the companies' shareholders. Rising bank earnings, at a time when the California economy overall still is struggling, provide those lenders with greater wherewithal--and incentive--to make local loans and thus help underwrite the economy's recovery.

The banks' gains also reflect, in part, the fact that a recovery is occurring--even though it may be tenuous in some regions of the state.

Carl E. Reichardt, Wells Fargo's chief, said that "a weak recovery appears to have taken hold in the California economy." While Wells' loans outstanding at June 30 were $34.17 billion, down slightly from $34.35 billion a year ago, Reichardt noted that the total rose 2% in the second quarter.

At First Interstate, the numbers look considerably better on the lending side, even allowing for the growth that has occurred through the company's many acquisitions of smaller banks. Corporate-wide, which includes operations in 13 western states, First Interstate said its net loans rose 7.8% in the second quarter from the first quarter, to $27.7 billion.

In California alone, commercial lending grew at a double-digit rate in the second quarter, the company said. "We're seeing terrific growth on the commercial side," asserted David Holman, head of First Interstate's corporate banking department in California.

At San Francisco-based Union Bank, the state's fourth-largest commercial bank, President Kanetaka Yoshida said commercial, industrial and consumer lending rose in the second quarter, while real estate construction lending declined. Overall, he said, the bank is seeing a "gradual recovery of the economic environment in California."

At the same time that the banks are benefiting from rising loan demand, their bottom lines are improving for another reason: Fewer existing loans are going bad--another indication that the state economy is getting better.

Wells Fargo, for example, said total non-performing and restructured loans fell to $717 million at June 30, compared to $900 million at March 31 and $1.91 billion on June 30, 1993.

Ahmanson, parent of Home Savings, said its non-performing assets slipped $14 million in the second quarter to $943 million, the lowest level since 1990. Ahmanson last year sold off $1.2 billion in bad loans, which helped clear its books but also raised fears that more problem loans had yet to surface. So far this year, however, the quality of Ahmanson's portfolio has continued to increase.

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Perhaps the biggest surprise for California banks in the first half of this year has been their ability to weather the sharp rise in short-term interest rates, as the Federal Reserve Board has tightened credit for the first time in five years.

When the Fed boosts short rates, banks' cost of funds--mainly in the form of deposits--is supposed to rise. Though banks also tend to increase loan rates as well in times like this, the spread between deposit costs and loan rates often narrows significantly as the economy expands--with the net effect of squeezing profits.

But that hasn't been a major problem for many California banks this year. First Interstate's net interest margin actually rose in the second quarter, to 5.10% from 4.99% in the second quarter of 1993.

Wells Fargo's net interest margin was 5.56% in the first half of this year, off only marginally from 5.81% in the first half of 1993.

For California's big banks and some S&Ls;, the relative strength in their net interest margins is a gift from a lot of mom and pop savers.

Many Californians left surprisingly large sums of money in low-yielding bank savings accounts and CDs over the past three years, even as short-term interest rates fell to 30-year lows. That provided the banks with a core of cheap money with which to fund themselves.

"First Interstate has had the lowest core deposit costs in the industry for at least 10 years," marvels Mark Lynch, analyst at Lehman Bros.

This year, even as interest rates on short-term U.S. Treasury bills have surged with the Fed's tightening, some California banks have managed to retain deposits with only minor increases in CD yields. Wells Fargo, for example, now pays 3.7% on a one-year CD, far below the 4.3% average yield of 30 major California institutions tracked by RateGram newsletter. Yet Wells' total deposits have held steady at $40 billion for the past year.

So long as their deposits stay put, most California banks and S&Ls; have little incentive to engage in a price war for funds that would drive up CD yields. The end result is that the biggest institutions are in stronger control of their own destinies: They can compete aggressively for loans to boost income, without fear of the cost side of the equation coming back to haunt them.

In essence, says Lynch, the banks "are making money off their depositors and giving it to the borrowers" in the form of loan incentives.

For investors, all of this means there's still potential to make money in some of the best-known California bank and S&L; stocks, many analysts say. Even though most of the stocks have jumped over the past two years, anticipating the current earnings recovery, the bulls argue that the surprise could be in the magnitude of California bank and S&L; earnings gains in 1994 and 1995.

Those gains should beat what companies in many other industries are capable of, the bulls say. At the same time, high dividend yields on the bank and S&L; stocks (often 3.5% or better) and low price-to-earnings ratios should increase their allure for investors.

Lynch, for example, believes that First Interstate shares, now $78, could reach $100 in 12 months as earnings expand.

Gary Gordon, analyst at Paine Webber, sees 20% capital gains potential in shares of Ahmanson and Great Western Financial from current levels. And don't forget that those California lenders, and others, also could be takeover targets, Gordon says: As the California recovery gains steam, more out-of-state banking giants are likely to buy their way into the Golden State.

The Californians

Stock prices and earnings projections for some leading California banks and S&Ls.;

Stock Est. earnings/share: Bank price 1994 1995 BankAmerica $47 1/2 $5.25 $5.75 Calif. Federal 12 -7.75 1.00 First Interstate 78 9.00 10.25 Glendale Federal 11 1/4 -2.85 0.40 Golden West 39 7/8 4.05 4.60 Great Western 18 7/8 1.55 2.50 H.F. Ahmanson 20 1/8 1.85 2.30 Wells Fargo 157 1/2 14.00 15.00

All stocks trade on NYSE.

Source: Value Line Investment Survey

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