TheStreet.com: Chris, why have the banks outperformed the broader market this year?

Christopher Marinac: Banks have outperformed primarily as a result of the aggressive interest-rate cuts from the Federal Reserve. In addition, the banking sector was the beneficiary of the significant money flows that left technology, telecom and other high-growth sectors beginning in late 2000 in search of safer havens. While banks have had and still have credit risk, the market seems to have decided that lower interest rates and far less earnings risk override the slowdown in the economy and the slightly higher risk banks assume as a result.

TheStreet.com: Just so we're all on the same page, how do lower interest rates help commercial banks?

Christopher Marinac: Lower interest rates can help banks, although not always, by lowering the costs of liabilities, which can increase the net interest spread -- the difference between what banks pay to attract deposits and the revenue received from rates charged for loans and captured from investments.

One caveat to lower interest rates is that they don't benefit all banks equally. The change in net interest spread is largely a function of the structure of a bank's assets (loans and investments) and liabilities (deposits). For example, some banks are focused almost exclusively on commercial loans, which are typically tied to the prime rate or a similar floating index. Those loans are funded by low-cost deposits, such as checking, money-market and savings accounts. However, this year's Federal Reserve rate reductions have been so aggressive that many banks have seen loan rates fall faster than the costs of deposits, which has caused the net interest spread to remain flat or, in some cases, even decline. What's ironic is that the marketplace appears to perceive the opposite, which is true for some banks but certainly not all.

Other banks have more balance between consumer and commercial lending. They tend to have larger residential real estate loan portfolios -- both primary mortgages and home equity loans -- and traditional consumer loans: auto loans and other personal lending. The spreads on those loans are typically greater and rates tend to be fixed, meaning as the Federal Reserve lowers rates, the net interest spread could widen. However, it is more difficult to generate large volume in consumer loans, unlike commercial lending.

This scenario is typical of a bread-and-butter community or small regional bank. The larger regional and money-center banks tend to have a much more sophisticated asset and liability balance, such that their net interest spread is largely unchanged during changes in the interest-rate cycle.

TheStreet.com: Let's talk about the economy and credit quality. The economy appears to be slowing, and that has some analysts worried about bad debt, especially on the commercial side of the lending ledger. Could bad debt really take a bite out of bank earnings going forward?

Christopher Marinac: So far, we have seen a sharp increase in credit losses and credit problems, but it has not put a dent in bank profitability. The positive offsets have been widening spread in some banks and increased fee income, primarily from traditional bank services -- overdraft fees, ATM charges, credit-card fees and the like.

Our expectation is that credit quality deteriorates further in the third and fourth quarters, but the rate of deterioration could slow, meaning less new problem loans than we saw in the first half of this year and the last half of 2000.

One wild card is that the Office of the Comptroller of the Currency, or OCC, is in the midst of completing a credit review of large bank lending and, specifically, syndicated loans, large credits that are shared by a number of banks. The OCC is likely to identify a number of potential problem loans not already considered problems by the banks, which could accelerate the growth in bad debts, causing banks to either increase loan-loss reserves or write off bad debt. This isn't a new phenomenon. The OCC has reported a major increase in October of each of the last three years.

The largest players in syndicated loans are Bank of America (BAC:NYSE - news - commentary) and J.P. Morgan Chase (JPM:NYSE - news - commentary).

TheStreet.com: What about the consumer side of the ledger? Many signs continue to suggest that the consumer is holding the economy together, but debt is becoming an ever-increasing burden. How could that affect the banking sector?

Christopher Marinac: Consumer delinquencies and consumer loss rates likely will increase. It seems unlikely that we can escape this risk. However, the absolute level of interest rates and the relative health in residential real estate seem to mute the level of downside. It is possible that we are way too optimistic about sustaining home prices, but barring a dramatic change in real estate values, we believe that the increase in consumer losses will be tolerable.

TheStreet.com: So you're not worried that we're approaching a housing price bubble? What about the statistic that shows owner equity in residential real estate is at an all-time low, only about 55%?

Christopher Marinac: Not necessarily. You have a stable amount of inventory. You have low interest rates, and you still have low absolute unemployment rates. Certainly that statistic is lower due the wider availability of credit in the form of home equity lines and second mortgages. But, if you step back, 55% equity still leaves a strong margin of error should real estate prices decline, even by a significant amount.

Statistics for mortgages issued in 2000 do show an increasing delinquency rate, but it remains low, about 0.16%. That's alarming if you consider that it has more than doubled from 0.07% from 1999 and is up from 0.05% in 1998, but in absolute terms, it remains quite low.

TheStreet.com: But, bottom line, you don't expect a lot of earnings impact from the increase in either commercial or consumer bad debt for the rest of this year and into next?

Christopher Marinac: Most earnings estimates continue to have a healthy charge-off rate for banks in the second half of the year. Next year, however, most analysts are pretty optimistic that credit costs will fall. To the extent that this is a faulty assumption, earnings growth in 2002 could feel the impact and have to be reduced.

I think we'll experience some sort of recovery in 2002, although it could be more modest than many hope for today.

TheStreet.com: You spend a significant amount of your time focused on the community banks of the Sunbelt. Since the money-center and super-regional banks get plenty of ink, let's focus on some smaller names. How can investors make money focusing on smaller, community banks?

Christopher Marinac: We favor an approach that is geographic and demographically based, as job growth and household formations are keys to future demand for banking services. Hence, we have a bias toward banks in North Carolina, Florida, Georgia, Texas and the Washington, D.C., metropolitan area.

These are all areas of high growth, that have the right demographics and a near-continuous inflow of new residents. This is important because those attributes tend to dictate growth in demand for banking services, especially lending and fee-based products and services. And, they drive new business formation and commerce growth, which is key in building lending volume.

As a result, the banks in these areas have a greater chance to post internal earnings growth well above the industry average without relying on mergers and acquisitions. In addition, banks with these characteristics tend to have a higher-than-average return on assets, a healthy sign. Those types of opportunities should be attractive to bank investors.

Banking Opportunities Under the Sun Sunbelt community banks that deserve a look
Company and Ticker	Recent Price	Per-Share Earnings Est.		P/E 2001E	Current Yield	Return on Assets
		2001	2002
Boston Private Financial (BPFH:Nasdaq)	$22.00	$0.85	$1.05	25.9	0.60%	1.45
Cullen/Frost Bankers (CFR:NYSE)	38.90	2.06	2.53	18.9	2.20	1.49
Mercantile Bankshares (MRBK:Nasdaq)	42.87	2.55	2.85	16.8	2.60	1.94
Seacoast Banking (SBCFA:Nasdaq)	42.95	2.88	3.12	14.9	2.60	1.27
Sterling Bancshares (SBIB:Nasdaq)	23.64	1.12	1.30	21.1	0.90	1.32
Source: SunTrust Robinson Humphrey, Company reports

TheStreet.com: What are your favorite banks for investors in those fast-growing areas?

Christopher Marinac: In the Washington area, Mercantile Bankshares (MRBK:Nasdaq - news - commentary). Mercantile's net interest margin -- one of the banks that actually saw its margin shrink -- should begin to stabilize and reverse once the Fed stops easing, which we think will happen by the fourth quarter. At $42.87, the stock could trade to $48 in the next 12 months. The bank has an exceptional management team, and its loan portfolio scores at the top of all of our credit-quality metrics -- comforting in uncertain economic times. In addition, the 2.6% yield is a nice bonus.

In Texas, Cullen/Frost Bankers (CFR:NYSE - news - commentary) and Sterling Bancshares (SBIB:Nasdaq - news - commentary). Both are real beneficiaries of solid demographics and have continued to benefit from business taken from the "big four" names in Texas banking: Bank One (ONE:NYSE - news - commentary), Wells Fargo (WFC:NYSE - news - commentary), Bank of America (BAC:NYSE - news - commentary) and J.P. Morgan Chase.

Texas is perhaps the best example of an oligopoly in banking, as the big four banks control nearly 60% of the deposit market in the large metro areas. This creates an umbrella under which the smaller regional and community banks can prosper and win business from the big four, particularly in the small-business arena. The smaller community banks traditionally provide a higher level of hands-on service and a very attractive fee structure, especially to small-business customers.

Cullen/Frost is a traditional commercial bank with a very inexpensive deposit base, which should provide for increased net interest spread as rates stabilize. In addition, it is beginning to raise its profile among investors after being relatively shy with Wall Street for many years. Currently at $39, it has potential to trade into the mid-40s.

Sterling is a unique community bank that focuses exclusively on small-business customers and has posted strong earnings. We think the strategy will continue to be successful, especially given the robust nature of Houston's energy-based economy. At $23.64, the stock could trade into the high 20s.

In Florida, Seacoast Banking (SBCFA:Nasdaq - news - commentary) looks attractive due to the scarcity of billion-dollar-plus independent bank franchises in Florida. Seacoast is particularly attractive given its positioning in the "Treasure Coast," north of West Palm Beach, including the affluent towns of Port St. Lucie and Stuart. We see significant growth potential above current levels. The bank's largest competitor is Northern Trust (NTRS:Nasdaq - news - commentary), which underscores the relative wealth in its primary market. While the stock is up over 60% this year to $42.95, it should trade into the high 40s. Seacoast also sports a 2.6% yield.

Finally, a real niche company, Boston Private Financial (BPFH:Nasdaq - news - commentary). It's a trust and private banking company based in Beantown but with a desire to expand its reach. The company has expanded into Northern California through its purchase of an asset management firm with an additional bank acquisition pending. The timing in California seems ideal as the technology bubble has burst and the attractiveness of diversified, long-term money management is in the forefront of many local investors' minds.

And, while the tech bubble may have popped, the creation of wealth in California and across the country should continue, especially as a record level of assets are transferred across generations. And the near-record pace of private business sales creates newfound liquidity for former owners that will seek assistance with investments.