Q1 2011 earnings for the U.S. banks demonstrated overwhelmingly positive trends again this quarter, including: (i) lower credit costs (PCLs/NCOs), (ii) declining “bad loans”, and (iii) higher revenues (rising margins/fee income).

Perhaps of greatest significance, net income totaled ~$20 bln, or $22 bln excluding one-time items, which is ~90% of pre-crisis levels of $25 bln. Of note, since the cycle began, pre-tax pre-provision earnings have increased ~25%, driving fully recovered profitability to over $30 bln. Despite the fact that the banks have recaptured ~90% of pre-cycle earnings in just 5 quarters, the relevant bank indices have not responded. In fact, the market capitalizations for the 493 publicly traded banks are still, on average, ~40% below their all-time highs.

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Much of the overhang of the sector relates to the mortgage risks of the largest banks, which continues to be the greatest focus of the market. Since Q1 2010, BAC, JPM, WFC, and C have incurred mortgage repurchase expenses of $14 bln (including ~$2.5 bln in Q1, which was down ~50% from Q4) and litigation charges of another $9 bln. Despite this, as a testament to their size and resilience, they continue to report substantial earnings (as they did again this quarter). We believe delinquency rates within the actual servicing portfolios provide powerful evidence supporting our view that these risks are manageable.

In the upcoming quarters, we expect the market to refocus on fundamentals, including rapidly approaching normalized earnings. With ~40% (or ~200) of all U.S. banks trading below tangible book value (i.e. their presumed liquidation value), and nearly all now profitable, the opportunities among the mid-cap banks are particularly significant.

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