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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 sticky situation infected almost the entire financial services industry, and 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.

Entering 2010, although the banking industry is dealing with liquidity and confidence challenges, 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.

Despite the government’s strong efforts, we continue to see bank failures. As the industry tolerates bad loans that were 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 banks, $162 billion has come back from the healthy banks who have repaid their TARP funds. Banks have paid an additional $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 financial institutions that have already repaid the bailout money include JPMorgan Chase (JPM - Free Report) , American Express (AXP - Free Report) , Goldman Sachs (GS - Free Report) , Morgan Stanley (MS - Free Report) , Capital One (COF - Free Report) , BB&T (BBT - Free Report) , US Bancorp (USB - Free Report) , Bank of America (BAC - Free Report) , Wells Fargo (WFC - Free Report) and Citigroup (C - Free Report) .

Following the U.S. Treasury’s announcement requiring the world’s banks 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 that 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 the 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.

For the last few quarters, the banks have mainly suffered from the losses in mortgages and Commercial Real Estate (residential construction) loans. Housing prices have continued to decline, and given the sharp increase in unemployment we anticipate continued losses in these portfolios.

While the state of the economy is showing signs of recovery, a lot remains to be done. The Treasury continues to have huge direct investments in institutions like American International Group (AIG - Free Report) , Fannie Mae and Freddie Mac (FRE).

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 we will have to wait awhile to write the end of this crisis story.

OPPORTUNITIES

The Treasury’s requirement of focusing 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 ranking of 1 (Strong Buy) include BancFirst Corporation (BANF), First Capital Bancorp, Inc. (FCVA) and Bridge Capital Holdings (BBNK).

There are currently a number of stocks in the U.S. banking universe with a Zacks ranking of 2 (Buy) including 1st United Bancorp, Inc. (FUBC), Ameris Bancorp (ABCB), Doral Financial Corp. (DRL), Tennessee Commerce Bancorp Inc. (TNCC), United Bankshares Inc. (UBSI) and North Valley Bancorp (NOVB).

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. 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 ranking of 5 (Strong Sell) including Southwest Bancorp Inc. (OKSB), Texas Capital BancShares Inc. (TCBI), Bank of Hawaii Corporation (BOH), Cathay General Bancorp (CATY), Central Valley Community Bancorp (CVCY), Pacific Continental Corp. (PCBK) and Summit State Bank (SSBI).



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