Enthused by strong second quarter performance, Morgan Stanley (NYSE:MS)’s research team enhanced its outlook for large cap banks.

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In their recent North America ‘large cap banks’ report, Betsy L. Graseck and team at Morgan Stanley Research are satisfied with strong performance by large banks on several fronts such as better credit, improving outlook for net interest margin, and net interest income. The strong performance has encouraged the analysts to enhance their capital return estimates.

Morgan Stanley: overweight call on 5 banks

Morgan Stanley analysts favor banks that have a greater tailwind to earnings with higher potential for rising estimates. The analysts feel such enhanced profit can be achieved through variety of factors such as (a) exposure to improving housing credit and loan growth, (b) outsized benefit to a higher long-end rate rise and (c) increasing upside to the analysts’ capital return estimates.

Based on these parameters, the analysts assigned Overweight ratings in five banks: Bank of America Corp (NYSE:BAC), Citigroup Inc. (NYSE:C), JPMorgan Chase & Co. (NYSE:JPM), SunTrust Banks, Inc. (NYSE:STI) and Regions Financial Corporation (NYSE:RF).

Downgrades two banks

Betsy L. Graseck and team have downgraded Capital One Financial Corp. (NYSE:COF) and PNC Financial Services Group Inc (NYSE:PNC), as they have already approached analysts’ price targets. The analysts feel both the banks are relatively less sensitive to the long end of the curve rising and improving housing.

The following picture depicts the analysts’ views on the top banks:

Morgan Stanley Price Targets On Banks

Improved housing loan growth

Elaborating further on assigning Overweight ratings on the five banks, Morgan Stanley analysts feel the second quarter improvement was better than expected at 10 of 12 banks. The analysts note the increasing home prices are driving down credit costs at these banks, particularly the regions where the housing recovery is more pronounced.

Long-end rate shifts to benefit

Betsy L. Graseck and team feel NIM was largely in line with their expectations for the second quarter. But, the forward outlook was still better for the large banks, as the analysts observed positive commentary across many of the banks. By using company disclosures, the analysts estimated a median 1.1 percent upside to their EPS estimates over a 12 month period from a 64 bp rate rise at the long end of the curve.

Capital return estimates

Better credit and higher NIMs have added to Morgan Stanley analysts’ conviction on increasing capital return. Betsy L. Graseck and team anticipate the median net buyback payout ratio will increase from 25 percent in 2013 to 41 percent in 2014, with further increase to 50 percent in 2015.