The worst of the credit crisis is now probably behind us, but the banking system is not yet out of the woods, as there are still many significant challenges ahead.

Ten of the nation's largest banks have received the Treasury approval for TARP repayment, as they are now able to tap the debt markets without FDIC's support and also access the equity markets as the investor confidence returns in the stronger banks.

While the bigger banks have benefited a lot from the various programs launched by the Federal Reserve, the Treasury and the FDIC, and are now in a much better shape, many smaller banks are still in a very weak financial state, and the FDIC's list of problem banks continues to grow. Further, government efforts have not succeeded in restoring the lending activity at the banks. Lower lending activity will continue to hurt the margins, though the low interest rate environment should be beneficial to the banks with a liability sensitive balance sheet.

For the last few quarters, the banks have mainly suffered due to the losses in the mortgages and Commercial Real Estate (residential construction loans). Housing prices have continued to decline, and given the sharp increase in the level of unemployment, we anticipate continued losses in these portfolios. Further, deterioration in other Commercial Real Estate loans is now rising at a rapid pace, and the downturn in this class is also likely to be very challenging.

With deterioration in the overall economic environment and rising job losses, we anticipate the losses will continue to increase in all the other asset classes as well, especially in the consumer related loans. It was recently reported that U.S. credit card delinquencies rose to a record high and are expected to rise further. We expect the asset quality deterioration to continue at least through the end of FY09.

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 in the coming quarters, affecting the profitability. Also, the banks will also continue to take mark-downs in the investment portfolios, further hurting the bottom-line.

OPPORTUNITIES

We recently upgraded our recommendation on Ocwen Financial Corp ( OCN - Analyst Report ) to a Buy, as this company may be a major beneficiary of the President's Home Affordable Modification Plan, which provides incentives for loan modifications to the borrower, the investor and the servicer. OCN was appointed by Freddie Mac ( ) as one of the servicers for the new pilot initiative launched to identify borrowers who are at a risk of foreclosure. Recently the Treasury extended TALF to include securities backed by servicing advances, which will provide comfort on the liquidity front.

WEAKNESSES

Banks with high exposure to housing and Commercial Real Estate loans, like Wilmington Trust Corporation ( ) , KeyCorp ( KEY - Analyst Report ) , Zions Bancorp ( ZION - Analyst Report ) will remain under pressure. We also continue our Sell recommendations on Freddie Mac ( ) and Sallie Mae ( SLM - Analyst Report ) , as we anticipate rising losses and increased provisions during FY09.