U.S. Banks Stock Update - August 2010 - Industry Outlook

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

After enduring extraordinary shocks in 2008, 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 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 entire world.



Although the banking industry is still grappling 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.

Impact of Financial Reform Law

In July 2010, President Obama signed a law to overhaul the banking system and Wall Street in an effort to reduce many of the practices that led the U.S. economy into its worst state since the 1930s.

Although the law -- the most sweeping financial reform since the Great Depression -- gives the government more power to tighten regulations for companies that threaten the economy, this may become a significant threat to profitability for the country's biggest banks in the near- to mid-term.

This law would partially restrict proprietary trading of commercial banks. Also, derivatives trading would be restricted, which are used to hedge risk or speculate the future value of assets. Further, banks will be banned from proprietary trading and will be able to invest only up to 3% of their Tier 1 capital in private equity and hedge funds.

As a result, a significant impact on profitability is expected for the big commercial banks including Morgan Stanley (MS), Bank of America (BAC), JPMorgan Chase & Co. (JPM), Wells Fargo (WFC), Goldman Sachs (GS) and Citigroup (C).

In addition, the government would set up a new process to liquidate troubled financial institutions. Also, the law would enhance consumer protection and compel banks to reduce risky trading and investing activities.

Bank Failures Continue

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. 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. Taxpayers have received decent returns on many of their financial-sector investments. Repayments under the TARP have generated a 17% annualized return from stock-warrant repurchases.



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.

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 (FNMA) and Freddie Mac (FMCC).



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. 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 (short-term Strong Buy rating) include BancFirst Corporation (BANF), Bancorp Rhode Island Inc. (BARI), Community Bank System Inc. (CBU), Horizon Bancorp. (HBNC), Merchants Bancshares Inc. (MBVT), MidWest One Financial Group Inc. (MOFG) and Princeton National Bancorp Inc. (PNBC).



There are currently a number of stocks in the U.S. banking universe with a Zacks #2 Rank (short-term Buy rating) including New Alliance Bancshares Inc. (NAL), Southwest Bancorp Inc. (OKSB), Bryn Mawr Bank Corp. (BMTC), Financial Institutions Inc. (FISI), Oritani Financial Corp. (ORIT), Macatawa Bank Corp. (MCBC), Chemical Financial Corp. (CHFC), Bank of Marin Bancorp (BMRC) and Northrim Bancorp Inc. (NRIM).



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 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. Though Commerce Bancshares has the scope to expand inorganically with its excellent liquidity position, we remain cautious on the company’s credit quality and loan volumes, where improvement is warranted for a firm foothold in the industry. 



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 financial 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 (short-term Strong Sell rating) including Encore Bancshares Inc. (EBTX), Arrow Financial Corporation (AROW), The Bancorp Inc. (TBBK), Hudson Valley Holding Corp. (HUVL) and Taylor Capital Group Inc. (TAYC).
 
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