Before diving into bank stocks, consider possible horrors

ByABC News
October 26, 2007, 2:21 AM

— -- Sometimes, things aren't as bad as they seem. They're worse. If you're thinking about buying some bank stocks now because you figure they can't possibly get uglier, remember that sometimes the light at the end of the tunnel is a one-eyed monster.

But if you really can't resist bank stocks now some have been beaten down by 30% or more this year then consider investing in the stocks of banks whose officers are buying, too. They may lead you to safety and if they don't, well, at least you won't suffer alone.

Bank stocks have been such a chamber of horrors this year that it's hard to know where to begin. Let's start with interest rates. For the past two years, banks have suffered because the difference between long-term interest rates and short-term rates was so narrow.

Here's why: A bank makes its money mainly by taking funds from depositors and then lending it out to businesses, home buyers and other borrowers. If a bank can pay you 3% on a one-year CD while charging you 6% for a 30-year mortgage, life (for the bank, anyway) is good. For much of last year, though, the spread between what banks pay on deposits and what they charge for loans was unusually narrow.

Because lower short-term rates can boost a bank's profit margin, bank stocks often rise when the Federal Reserve cuts its target for short-term interest rates. But regional bank stocks have tumbled 7.8% since the Fed cut its key federal funds rate on Sept. 18. Stocks of big money-center banks have fallen 7%.

Why? Blame the subprime mortgage debacle. Because interest margins were so narrow and the housing market was so frothy, banks began making high-interest loans to shaky borrowers. This rarely ends well. And it hasn't this time, either.