For banks, some good news (finally)

The US banking industry isn't out of the woods, but it appears to at least have a map and a compass. That's the picture – and it's a promising one for ordinary Americans and the economy – that emerges from second-quarter earnings reports released in recent days.

Just a few months ago, worry was rampant that a tottering financial industry might push the US and world economies into a depression. That concern has receded sharply. In fact, many large banks have posted profits that beat analysts' expectations, while also moving to pay back government bailout money.

On Wednesday, Wells Fargo reported earnings of $2.6 billion for the second quarter, following similar profit reports with "upside" surprises last week at Bank of America ($2.4 billion), Citigroup ($3 billion), and JPMorgan Chase ($2.7 billion). Those are the nation's four largest banks in deposit and lending activity.

This doesn't mean that these banks and others are already back to health. Their profits reflected the impact of ongoing government aid, and some one-time boosts such as asset sales. Their losses on loan defaults are high, and are continuing to rise. But the latest trends suggest that the banks are on their way to navigating out of a historic crisis.

For American households, the key result is that credit is more available than it would otherwise be.

"Many households and businesses are finding credit difficult to obtain," Federal Reserve Chairman Ben Bernanke told Congress this week. "Nevertheless, on net, the past few months have seen some notable improvements."

The pace of an economic recovery will depend partly on how well and how quickly banks and credit markets heal, economists say.

The big problem for banks is loan defaults, driven by a rising unemployment rate and the decline in real estate values. Banks are charging off bad loans at a pace that exceeds the peak seen during another bad credit crunch, in the early 1990s, according to Federal Reserve data. And the trend line for charge-offs is still rising. (see accompanying chart)

How far will bank losses rise? And will other sources of profit be enough to offset them, so that banks have the means to keep making new loans? Those are vital questions.

In June, forecasters at the investment firm Goldman Sachs shifted their view in an upbeat direction. They argue that, unlike Japan's experience in the 1990s, US banks will generally be able to earn their way out of trouble as profits outweigh the tide of loan losses.

The Fed, in its effort to prevent a collapse in the flow of credit for consumers and businesses, has been keeping short-term interest rates low. That helps bank profits, as many lenders reduce the interest they pay out for deposits faster than they cut their own lending rates.

Even with big help from the Fed, banks are still under extraordinary strain.

For example, Citigroup's profit reflected a windfall of $6.7 billion for the sale of its Smith Barney division -- something that won't be repeated next quarter. And on Wednesday, Morgan Stanley reported a big loss on its real estate investments -- a disappointment following the profits reported earlier this month by its investment banking rival Goldman Sachs.

Such firms will have to keep making progress for credit conditions to fully normalize. But a potentially catastrophic meltdown now appears to be a risk that is fading.

As he questioned Mr. Bernanke Wednesday, Sen. Charles Schumer (D) of New York said the threat of an economic depression had been averted. "We should remember where we were six months ago and where we are today, and give you some credit for that," he told the Fed chief.

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