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U.S. banks still not out of the woods

After more than a year of bruising financial turmoil, U.S. banks have some good news to report. Profits have been surprisingly strong for the first quarter of the year.

Beyond those headlines, though, the outlook is still tough. With big piles of bad assets remaining and a weak economy ahead, the banking industry is still a long way from regaining a solid footing.

The latest news came from Citigroup, which reported its smallest quarterly loss since 2007 on Friday and had better-than-expected results overall.

Banks haven’t been shy about getting the good news out. Last month, Citigroup CEO Vikram Pandit tried to calm nervous investors, customers and employees, issuing a widely read memo declaring that the bank was profitable in the first two months of the year.

Last week, Wells Fargo said it expected to post a profit for the latest quarter; the bank said loan losses would be far lower than Wall Street analysts had been expecting. On Thursday, J.P. Morgan Chase said it was able to set aside another $4 billion against future loan losses and still post a $2 billion profit for the first quarter.

Investors have responded accordingly. In the past week, shares of Citigroup, JPMorgan, Bank of America and Well Fargo have surged, and broad stock market indexes are at their highest levels since early February.

But the good news comes with a few important asterisks, according to some investors and bank analysts. The biggest one: Although the revenue coming in the door may be higher than the cost of doing business, the banking industry still has a gigantic mess to clean up from the misguided lending spree that produced trillions of dollars of losses and bad loans.

Wells Fargo’s results, for example, were clouded by the fact that it closed its acquisition of Wachovia during the quarter, combining two sets of books into one.

“There was a one-quarter benefit,” said Whitney Tilson, an investment manager at T2 Partners hedge fund. “The reason not to get overly excited about this is, as we look at Wells Fargo's loan book, they'll have a lot of losses over the next couple of years.”

Despite the industry’s huge pile of shaky loans, it’s no mystery why many banks are making cash hand over fist. Since the financial panic began last fall, the Federal Reserve has been leaning heavily on interest rates, pushing the bank industry’s borrowing costs down to nearly zero. If you’re a banker lending that free money back to customers for, say, 5 percent, it’s pretty hard not to make money.

The Fed’s hope is that banks can generate cash quickly enough to fill the multitrillion-dollar hole in their books created by the meltdown of the housing market and the recession. Overall, the strategy seems to be working.

As long as the Fed keeps interest rates near zero, banks should continue to generate fresh cash. But as that money comes in one door, it’s flowing out another as the slump in business activity and rise in unemployment pushes more borrowers into default.

"Certainly on the commercial and credit card (loan) portfolios, we're seeing credit quality continue to deteriorate there,” said Jeff Harte, a bank analyst at Sandler O'Neill.

While banks are hauling in cash on the loans they’re making, their return to the black won’t help get the economy moving again until the overall volume of loans begins expanding. The news on that front has not been promising this week.

The Treasury’s latest monthly tally of lending from the nation’s biggest banks showed nine reported increases and 12 posted declines. The median, or midpoint, for lending activity dipped 2.2 percent in February. The sharp drop in mortgage rates has boosted lending in that category by 35.4 percent; home equity lines of credit were up. 17.7 percent. But lending to businesses plunged 47 percent.

It’s at all not clear just how much more money banks will lose from the hundreds of billions of dollars worth of loans and investments backed by real estate and other consumer loans that may yet default. Though home sales have perked up a bit, prices are still falling.

Despite the government’s recent efforts to halt home foreclosures, the pace has recently picked up again. Earlier this year, most lenders put a halt to foreclosures until the details of the government plan were worked out. Now that those halts have expired, lenders have picked up the pace of foreclosures on households that aren’t good candidates for loan modification or refinancing.

As a result, the number of households facing foreclosure grew 24 percent in the first three months of this year, according to data released Thursday. Nearly 804,000 homes got at least one foreclosure-related notice from January through March, up from about 650,000 in the same time period a year earlier, according to RealtyTrac Inc., a foreclosure listing firm.

It’s tough for banks to forecast how many more defaults are coming. In the early stages of the housing meltdown, many borrowers fell behind because they faced big jumps in payments from adjustable mortgages, which are relatively easy to modify to more affordable terms. More recently, mortgage defaults have been driven by rising unemployment; it’s much harder to provide foreclosure relief for borrowers who lose their income.

Lenders also face a looming problem with bad loans on commercial real estate. Many of these properties were financed with loans that come due in the next few years; refinancing those loans is tougher as credit standards have been tightened.

Commercial property owners are also getting hit by the recession.

On Thursday, the nation's second-largest shopping mall owner, General Growth Properties, filed for Chapter 11 bankruptcy protection in a move to restructure its $27 billion in debt. The company owns more than 200 malls including Faneuil Hall in Boston and the South Street Seaport in Manhattan.

A lot, of course, depends on how much further the economy slides. Most forecasters expect growth to begin to pick up by the end of the year, with unemployment continuing to rise well into 2011. But no one really knows. And some banks were a lot more exposed to risk than others when the panic hit.

That’s why the Treasury Department insisted on a giving a “stress test” to the banks that have taken some of the $200 billion the government exchanged for bank stock. Bank auditors have been combing through the industry’s loan portfolios and assets to see which banks were the most vulnerable if the recession turns out to be longer or deeper than expected.

That “stress test,” in turn, was supposed to give more confidence to private investors. The hope was that they would then inject more capital into the banking system after the Treasury ran into political opposition to expanding the bank bailout.

Now, even as investor confidence is slowly returning, some analysts say the plan may backfire.

“It is a political game,” said Richard Bove, a bank analyst with Rochdale Securities. “I think that what they have now done is backed themselves into a corner because they have to disclose which banks are not doing well.”