Amid the Turmoil, Small Banks Are Hidden Gems

We have all seen the headlines out of financial stocks in recent month: writedowns, write-offs, rising credit losses and reduced earnings. Not only is it not pretty, it has been downright ugly. If the Wachovia (WB - commentary - Cramer's Take) report today is any indication of what we can expect this quarter, it is not going to get any prettier anytime soon.

The financial stocks have been falling like rocks, and the analyst who has been the most accurate on the group of late, Whitney Meredith of Oppenheimer, is predicting that they have a lot farther to fall. If she is right, and if the major bank stocks trade at or near tangible book value, we could be talking about losses of as much of an additional 50% for many of them.

Dividends are being slashed to the bare minimum. They should probably be eliminated, but there are too many funds and pension accounts that are not allowed to own stocks with no dividends. To completely eliminate the dividend could cause enormous selloffs in stocks like Washington Mutual (WM - commentary - Cramer's Take) and Wachovia, so these companies continue to pay a minimal dividend.

There is something else going on with the money-center banks. As the losses from subprime and credit-related losses have mounted, these banks have been forced to raise new capital. This capital is not coming from a typical shareholder base of mutual funds and individual investors. It has come from hedge funds, private-equity funds and even foreign sovereign wealth funds.

In some cases we have seen large private-equity funds end up with a controlling stake in the bank; this is going to change the business model of these institutions. The focus will not be on customer service and the depositor and shareholder base. It will be on maximizing the immediate return to the larger investors. In my opinion, this is going to lead to a focus on increasing fees to depositors and borrowers, restrictive credit policies and direction of cash flow for the benefit of the institutional investors.

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At the time of publication, Melvin had no positions in stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.