U.S. Banks Stock Update - May 2010

Although a major recovery in the asset markets has been witnessed in recent quarters, the outlook for the U.S. banking industry still remains in question due to several negatives, including asset-quality troubles, drawbacks of new regulations and the continuation of both residential and commercial real estate loan defaults.

After enduring extraordinary shocks in 2008, the U.S. banks entered an exceptional state of turmoil in 2009. Starting as a credit issue in the subprime segment of the mortgage market, the situation affected about the entire financial services industry, in all corners of the globe. In other words, the financial crisis ultimately morphed into a massive economic crisis, which has had major ramifications across the whole world.

Although the banking industry is dealing with liquidity and confidence challenges in 2010, it is now comparatively stable, with financial support from the U.S. government. The government had taken several steps, including programs offering capital injections and debt guarantees, to stabilize the financial system.

We believe that the worst of the credit crisis is now behind us. After more than a year of initiating the $700 billion Troubled Asset Relief Program (TARP), a lot has improved with respect to the economic crisis.

But the banking system is not yet out of the woods, as there are persistent problems that need to be addressed by the government before shifting the strategy to growth. We believe that the U.S. economy will regain its growth momentum once these issues are resolved.

While the bigger banks benefited greatly from the various programs launched by the government, many smaller banks are still in a very weak financial state, and the Federal Deposit Insurance Corporation’s (FDIC) list of problem banks continues to grow.

Bank Failures Continue

Despite the government’s strong efforts, we continue to see bank failures. Tumbling home prices, soaring loan defaults and a high unemployment rate continue to take their toll on small banks. As the industry tolerates bad loans made during the credit explosion, the trouble in the banking system goes even deeper, increasing the possibility of more bank failures.

Furthermore, government efforts have not succeeded in restoring the lending activity at the banks. Lower lending will continue to hurt margins and the overall economy, though the low interest rate environment should be beneficial to banks with a liability-sensitive balance sheet.

Out of the $247 billion given to the banks, more than half has come back from the healthy banks who have repaid their TARP funds in full. Banks have also paid about $11 billion in interest and dividends. Also, taxpayers have received decent returns on many of its financial-sector investments. Repayments under the TARP have generated a 17% annualized return from stock-warrant repurchases and $12 billion in dividend payments from dozens of banks.

Many of the major banks that have already repaid the bailout money include JPMorgan Chase ( JPM - Analyst Report ) , Goldman Sachs ( GS - Analyst Report ) , Morgan Stanley ( MS - Analyst Report ) , BB&T (BBT), US Bancorp ( USB - Analyst Report ) , Bank of America (BAC), Wells Fargo ( WFC - Analyst Report ) and Citigroup ( C - Analyst Report ) .

Following the U.S. Treasury’s appeal to the world banking system to maintain stronger capital and liquidity standards by the end of 2010 to prevent a re-run of the global financial crisis, 15 large banks that control the majority of derivative trading worldwide have committed themselves to maintaining greater transparency in the $600 trillion market, which needs stricter oversight in the interest of the global financial system.

Moreover, in mid-January 2010, the Obama Administration proposed a tax on about 50 of the nation's largest financial firms in order to recover the losses incurred by the government on its $700 billion bailout program. On approval of Congress, the tax, which the White House calls a "financial crisis responsibility fee," would force the banks to reportedly pay the federal government about $90 billion over 10 years.

Targeting banks to recover the shortfall in bailout money can be considered justified, as they are the major beneficiaries of the taxpayers' largesse. Most of the bailout loan was provided to financial institutions, as they form the backbone of the economy and were the primary victims of the crisis.

If the economic recovery tails off, high-risk loan defaults could re-emerge. About $500 billion in commercial real estate loans would be due annually over the next few years.

Above all, there are lingering concerns related to the banking industry as well as the economy. Continued asset-quality troubles are expected to force many banks to record substantial additional provisions at least through the end of 2010. This will be a drag on the profitability of many banks for extended periods, which will further stretch their capital levels.

While the economy is in a recovery phase, a lot remains to be done. The Treasury continues to hold huge direct investments in institutions like American International Group (AIG), Fannie Mae (FNM) and Freddie Mac (FRE).

Additionally, rating agency Standard & Poor's said in March 2010 that it is maintaining its negative outlook for the U.S. banking industry based on FDIC’s industry financial performance data as of the end of 2009. The agency expects credit losses in the loan books of banks to be on the upside. Further, the agency warned that the pressure on ratings has not yet fully eased.

In conclusion, we expect loan losses on commercial real estate portfolio to remain high for banks that hold large amounts of high-risk loans. Also, as a result of a rise in charge-offs, the levels of reserve coverage have fallen over the past quarters and the banks will have to make higher provisions at least in the near term, affecting their profitability. We think that the financial crisis is far from over, and it will be awhile before we can write the end to this crisis story.

OPPORTUNITIES

The Treasury’s requirement of focusing on banking institutions towards higher-quality capital will help banks absorb big losses. Though this would somewhat limit the profitability of banks, a proper implementation would bring stability to the overall sector and hopefully address bank failures.

Specific banks that we like with a Zacks #1 Rank (Strong Buy) include Central Valley Community Bancorp ( CVCY - Snapshot Report ) , Financial Institutions Inc. ( FISI - Snapshot Report ) , S&T Bancorp Inc. ( STBA - Snapshot Report ) , Bank of the Ozarks, Inc. ( OZRK - Snapshot Report ) , First Community Bancshares, Inc. (FCBC), Republic Bancorp Inc. (RBCAA) and Old National Bancorp. (ONB).

There are currently a number of stocks in the U.S. banking universe with a Zacks #2 Rank (Buy) including Mainsource Financial Group (MSFG), Bancorp Rhode Island, Inc. (BARI), MBT Financial Corp. (MBTF), Mercantile Bank Corp. (MBWM), MidWest One Financial Group, Inc. (MOFG), Tower Financial Corporation (TOFC), BancFirst Corporation (BANF), Southwest Bancorp Inc. (OKSB), Viewpoint Financial Group (VPFG), Center Financial Corporation (CLFC), North Valley Bancorp (NOVB), Summit State Bank (SSBI), Washington Banking Co. (WBCO), Washington Trust Bancorp Inc. (WASH), Lakeland Bancorp Inc. (LBAI), Fidelity Southern Corporation (LION) and Cardinal Financial Corp. (CFNL).

We favor Commerce Bancshares Inc. (CBSH) in this space since this company is one of the few names that did not report losses even during the current financial crisis. We believe that Commerce is one of the best-capitalized banks in the industry and will generate positive earnings throughout the credit cycle. While the bank had a decent growth in deposits in the most recent quarter, trends in its credit metrics were negative.

WEAKNESSES

The financial system is going through massive de-leveraging, and banks in particular have lowered leverage. The implication for banks is that the profitability metrics (like returns on equity and return on assets) will be lower than in recent years.

Furthermore, the current crisis has dramatically accelerated the consolidation trend in the industry. As a result, failure of a large financial institution will be a major concern in the upcoming quarters as weaker entities are being absorbed by the larger ones.

We think banks with high exposure to housing and Commercial Real Estate loans, like Wilmington Trust Corporation (WL), KeyCorp (KEY) and Zions Bancorp (ZION), will remain under pressure.

Also, there are currently a number of stocks with a Zacks #5 Rank (Strong Sell) including Nara Bancorp Inc. (NARA), Sierra Bancorp (BSRR), Bryn Mawr Bank Corp. (BMTC), Horizon Bancorp (HBNC), Hudson Valley Holding Corp. (HUVL), Legacy Bancorp Inc. (LEGC), VIST Financial Corp. (VIST), Metrocorp Bancshares Inc. (MCBI), Firstbank Corporation (FBMI) and First Financial Bancorp (FFBC).