U.S. Banks Stock Update - January 2011 - 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 and policy changes.

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 U.S. banking industry is still grappling with weak revenue, diminishing loan demand and low liquidity 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. Also, the banks are working hard to address problem credits that are primarily concentrated in residential and commercial real estate.

We believe that the worst of the financial crisis is now behind us. Almost 2 years after initiating the $700 billion Troubled Asset Relief Program (TARP), a lot has improved with respect to the economic crisis. TARP has so far been less expensive for taxpayers than was expected earlier.

According to the Congressional Budget Office (CBO), cost related to TARP is expected to drop to $25 billion from $66 billion estimated in August 2010. Though $25 billion is not a small amount, the benefits already achieved by the program has been able to silence quite a few detractors. Also, the program has already earned about $35 billion in income.

With more banks releasing reserves, we expect provision for loan losses will continue to decline in 2011. Also, the problems with small banks are expected to result in a wave of consolidation in the industry.

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.

Banks are now 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.

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.

The implementation of Basel III will further have a short-term negative impact on the financials of U.S. banks.

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.

In all, there are lingering concerns related to the banking industry as well as the economy. 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 Fannie Mae (FNMA) and Freddie Mac (FMCC).

However, according to an article published by Standard & Poor's on December 1, 2010, the rating agency believes that U.S. banks are preparing themselves to deal with the challenges in 2011. The agency expects the profitability of U.S. banks to improve slowly with the fall of credit costs.

Additionally, Fitch Ratings' outlook on the banking industry remained stable for 2011. The rating agency expects the financials of banks to improve modestly as the macro conditions will take some time to stabilize.

In conclusion, we expect loan losses on commercial real estate portfolio to remain high for banks that hold large amounts of high-risk loans. Though it will be a while before we can write the end for this crisis story, banks are expected to perk up gradually in 2011.

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 Sandy Spring Bancorp Inc. (SASR) and Bank of the Ozarks Inc.
(OZRK).

There are currently a number of stocks in the U.S. banking universe with a Zacks #2 Rank (short-term Buy rating) including BancFirst Corporation (BANF), Southside Bancshares Inc. (SBSI), The Bank of New York Mellon Corporation (BK), Eagle Bancorp Inc. (EGBN), First Commonwealth Financial Corp. (FCF), Horizon Bancorp. (HBNC), Valley National Bancorp (VLY), Cascade Bancorp (CACB) and Western Alliance Bancorporation (WAL).

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) 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 Metro Bancorp Inc. (METR), TriCo Bancshares (TCBK), Washington Banking Co. (WBCO), Princeton National Bancorp Inc. (PNBC) and TCF Financial Corporation (TCB).
 
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