California's small and midsize banks have long been a bellwether for the nation's community institutions as a whole. So given the third-quarter performance of the Golden State banks so far this earnings season, there's reason for some optimism.

The 16 banks in California that reported third-quarter results through Oct. 18 recorded a 66% boost in average net income compared with a year earlier and a 23% jump from the second quarter, according to data from SNL Financial LC.

Analysts saw a ray of hope for the industry given the large number of banks in the state. Yet they cautioned against proclaiming a turnaround in community banking based on these results.

First, they said better performers tend to report early. And while most of the gains are real, the improvement stems partly from reduced loan-loss provisions compared with 2009's third quarter.

"Banks already have a pretty high allowance for loan losses so I don't think there is much more that they can set aside," said Rick Levenson, the president of Western Financial Corp., an investment banking firm in San Diego. "Maybe earnings have improved by virtue of the fact that they are putting less into their provisions."

Among the 13 California banks that included provisions in their preliminary earnings reports, nine had lowered them compared with the year-earlier period.

All but one of the 16 banks posted an increase in net income for the third quarter. Those banks included the $4.3 billion-asset Farmers and Merchants Bank of Long Beach, which reported an 11% increase in earnings, while its provision fell 48%; and the $1.3 billion asset Sierra Bancorp in Porterville, which boosted earnings by 737% on a 39% decline in its provision.

Likewise, First PacTrust Bancorp Inc. in Chula Vista more than doubled its net income to $3 million while dropping its provision to $781,000 from $2.7 million a year earlier.

An estimated 146 community banks in California have not yet reported earnings.

Provisions are lower because new problem loans are leveling off. Analysts do not, however, view this as evidence of a major improvement in credit quality.

"Investors are not concerned about quarterly profits as much as they are concerned about banks getting credit quality shaped up," said Tim O'Brien, a banking analyst in California at Sandler O'Neill & Partners LP. "If early indications are a sign of what is expected … at best, there will be incremental credit problems."

Of the eight banks that included nonperforming data, one had an increase, three had slight declines and four had no nonperforming assets when compared with the second quarter.

Two factors underlie the banks' earnings mix — a low interest rate environment coupled with stagnant loan demand, a combination that is causing banks to chase earnings by investing in securities rather than by making loans.

"Whether they like it or not, this is happening in a lot of cases," O'Brien said.

Typically, when loans carry a higher interest rate, they produce a better rate of return compared with investments in securities. But with interest rates so low, banks are finding that securities can provide comparable-to-better outcomes — and with a lower risk, which also helps their capital ratios.

Michael Perry is quite familiar with this set of circumstances. As the chairman, president and chief executive of San Diego Trust Bank, he led his $191.7 million-asset institution to a 31% increase in net income, to $218,000, in the third quarter largely from returns on the bank's securities portfolio.

By investing in mortgage-backed, government-guaranteed securities and municipal debt, "The bank's high-grade securities portfolio yielded approximately 400 basis points more than Fed funds without incurring undue duration risk," Perry said.

The bank had fortunate timing and pulled out of construction lending in late 2006. While its total loan portfolio declined about 4% in the third quarter compared with a year earlier, about 70% of its total assets are cash and securities held for sale. San Diego Trust posted its 24th consecutive quarterly profit in the third quarter.

In contrast, United Security Bancshares in Fresno is still feeling the effects of the state's real estate recession. The bank reported a 41% drop in net income, to $410,000, in the third quarter largely because of a decrease in its interest income and a jump in its loan-loss provision. Dennis Woods, United Security's president and chief executive, said in a press release Friday that its earnings were hurt after the homebuyer tax credit expired earlier this year.

Yet Woods said he's hopeful that the "ultra-low mortgage rates" may spur future home sales. Analysts agreed, adding that the low rates are helping borrowers pay down debt, thereby keeping some loans in performing status despite lower property valuations. Still, analysts said, banks and borrowers should not get too comfortable with the Federal Reserve's present stance.

"There is virtually no expectation that the Fed will increase short-term interest rates. But things could change pretty quickly," said Matt Anderson, managing director at Foresight Analytics.

"The danger would be if they become complacent with where they are now and there's a feeling that low interest rates would last indefinitely."

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