Published: September 1, 2009

The losing sector from 2008 could end up being the winner in 2009.

Financials were at the epicenter of the market collapse and credit crunch. Once-revered financial institutions such as Bear Stearns and Lehman Brothers were forced into bankruptcy.

Not surprisingly, they were the worst-performing market sector in 2008, falling -57% versus a -38% drop for the S&P 500 as a whole.

But financial stocks have seen a dramatic reversal of fortune in recent months. The sector has been the best performer in the S&P 500 since the index's early March lows.

The banking industry continues to face headwinds. Prime among those is a continued rise in loan-related losses -- which can be evaluated as a bank's non-performing loans (NPLs). NPLs include mortgage loans in foreclosure, loans on which interest payments aren't being met or loans that have been restructured or renegotiated.

Take Bank of America (NYSE: BAC) as an example of NPL trends. NPLs totaled about 0.25% of total assets in 2006. That ratio had soared to more than 2.9% as of last quarter. NPL trends could continue to deteriorate further in coming quarters as home foreclosures continue to work through the banking system.

There are some positives on the horizon:

Steep Yield Curve
The yield curve is a graphical depiction of interest rates for bonds of different maturities.

The rates that banks pay to depositors are typically tied to short-term bond yields. The bankers then loan out those funds at rates that are benchmarked to longer-term yields. That's why investors will hear that bankers "borrow short and lend long."

Bankers make a lot of money on their lending operations when the spread between short-term and long-term rates is wide.

The current U.S. yield curve is far steeper than a year ago thanks largely to the Federal Reserve's efforts to slash short-term interest rates. Low rates should help push up demand for loans, and the steep slope of the yield curve will lead to stronger profit margins.

The Troubled Asset Relief Program (TARP), the Term Asset-Backed Lending Facility (TALF) and the Public-Private Investment Plan (PPIP)
TARP and TALF are Federal government programs instituted to help alleviate the effects of the global credit crunch. TARP is a $700 billion program the government used to inject cash into the financial system by purchasing preferred securities of U.S. banks. TALF is a $1 trillion program managed by the New York Fed that allows financial institutions to post asset-backed securities as collateral against loans from the Fed.

PPIP is a government partner program in which investors purchase assets such as mortgage-backed bonds and bonds backed by credit card receivables directly from major U.S. banks.

All three programs are meant to address major concerns about the U.S. financial system. Chief among those was a fear among many market participants that big financial institutions were undercapitalized -- these firms didn't have enough capital to support their loans.

The London Interbank Offered Rate (LIBOR) is the rate banks charge to lend to one another. In the wake of Lehman Brothers' bankruptcy last year, banks no longer felt comfortable with the financial stability of their peers and LIBOR rates spiked to about 5%. Government programs have helped to alleviate these concerns and LIBOR rates now stand at less than 0.35%.

Stress Test and Renewed Confidence
The government conducted stress tests on 19 major financial institutions this year.

The results were published in May, indicating a minimal need for most banks to raise additional capital. Many of the banks that do need to raise capital are doing so privately -- attracting private investments rather than the federal government. This suggests rising confidence among investors in the long-term health of the banking system.

Not all U.S. banks are in the same boat. Some avoided the riskiest residential lending markets and have plenty of capital to survive the current weak economy. These banks stand well-placed to grab market share, making loans at attractive rates in an environment where weaker players are pulling in their horns.

Some banks have taken advantage of the current environment to buy their competitors. In many cases, acquisitions were made at fire-sale prices during the global credit crunch.

This sector has bounced back from historic lows on the back of government assistance, but it is showing signs of life on its own. Looking ahead, expect share prices to continue following suit as markets recover.

-- Nathan Slaughter
Editor
Half-Priced Stocks

P.S. -- Not all U.S. banks are in the same boat. Some avoided the riskiest residential lending markets and have plenty of capital to survive. These banks stand well-placed to grab market share, making loans at attractive rates in an environment where weaker players are pulling in their horns. One of them -- considered the best-managed bank in America -- actually thrived through the downturn and hiked its dividend six times since the crisis started. I call it my "Money Doubler #1" -- and it's my favorite bank stock to own today. You'll find its name and ticker symbol in this report.