Before diving into bank stocks, consider possible horrors

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.

Cleveland-based National City Bank ncc paid out $896 million in interest to depositors in 2004 but collected far more — $5.5 billion — in interest and fees on loans. By the end of 2006, its interest and fee income had grown smartly, to $8.9 billion. But the interest it paid on customers' deposits had soared, to $2.4 billion.

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.

As mortgage defaults have risen, bank after bank has announced horrible third-quarter earnings. Bank of America's bac third-quarter earnings were 32% below the level of the third quarter of 2006. Much of BofA's profit shrinkage came from its global investment banking unit, whose earnings fell 93% during the third quarter.

If you're the type of investor who likes to buy stocks after they've been hammered, bank shares are the kind of stocks you'd favor right now. Bank of America shares have fallen 5.1% since the Fed's September rate cut. Its dividend yield has soared to 5.3% — more than you'd get from the average money market fund. National City Bank's stock has fallen 8.9%. Its dividend yield: 6.9%. What could go wrong?

Plenty, says James Abbott, an analyst at Friedman Billings Ramsey, an Arlington, Va., investment bank. "Banks have a lot more problems than subprime," he says. Loan defaults are rising for all borrowers, even those with high credit ratings, Abbott notes. "Everyone's credit is deteriorating."

If consumers rein in their spending, commercial lending will suffer as well. If people start to spend less, small businesses, such as restaurants, will start going out of business. "It's not a pretty picture, in my view," Abbott says. He doesn't foresee improvement until the end of 2008.

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