Clean Money at Regional Banks

Investing in big banks has been a roller coaster this year, with stocks like Citigroup C and J.P. Morgan Chase JPM down one week, up the next.

That kind of volatility may please hedge funds and the few remaining daytraders, but for most investors it's the kind of gut-wrenching market action that they can do without.

Investors in the stocks of regional banks are experiencing a much smoother ride.

Stealth Rally

Indeed, in a year when the average bank stock as measured by the Philadelphia KFB Bank Index is down 8%, many regional banks actually are trading higher. Some of the sector's standout performers: New Jersey's Commerce Bancorp CBH, up 21%; Melville, N.Y.-based North Fork BancorpNFB, up 31%; and Alabama's AmSouth Bancorp ASO, up 20%.

Like all lenders, regional banks are benefiting from a low-interest rate environment that has spurred consumer borrowing for auto loans, mortgages and home-equity lines of credit. But unlike commercial banks, the regional banks have avoided taking hefty writedowns on their business loan portfolios, since most weren't big lenders to the troubled telecom, technology and energy sectors.

Regional Players
Bank	YTD % Gain	2002 PE	2003 PE	Dividend Yield
AmSouth BancorpASO	20	17	12.5	3.9%
Commerce BancorpCBH	21	23	20	1.3
Fifth Third BancorpFITB	8.5	24	21	1.4
North Fork BancorpNFB	31	16	15	2.4
UnionBanCalUB	14	13	11	2.6
Source: Thomson Financial First Call

The bulk of commercial lending by regional banks is to real estate developers and homebuilders, the one sector of the economy that has shown surprising strength throughout the recession.

And unlike a diversified financial institution like J.P. Morgan, most regionals don't rely on investment banking work to generate a big chunk of their revenues. Even better, the fact that the regional banks don't get involved in investment banking means they've managed to stay clear of the conflict-of-interest scandals that are dogging most Wall Street firms.

"It's still a favorable environment for regional banks," says Gary Townsend, a regional bank analyst with Friedman Billings Ramsey, who doesn't own shares in the banks he covers.

9 to ??

But the trouble for investors is that with so many regional banks bucking the overall market trend, it's unclear how much longer the good times can last and whether it's too late to buy shares in the top performers.

If the economy sours, as some on Wall Street fear it will, consumer borrowing could dry up and shut off a main revenue driver for regional banks. Additionally, a dreaded double-dip recession would mean higher unemployment and the potential for higher levels of consumer defaults. And if the housing market -- which some insist is another bubble ready to pop -- suddenly slumps, it could mean trouble for all the commercial real estate loans the regional banks have made.

Yet, most banking industry analysts remain upbeat about the prospects for regional banks because they have strong local ties to the consumers that deposit money with them and the businesses they lend to. Some suggest that this up-close and more personal style of banking has made regional bankers better judges of risk than some of their bigger competitors.

"We think the regional banks have structurally a strong franchise," says Sean Jones, a bank analyst with Moody's Investor Service, the corporate rating agency. "We believe they know their client base very well."

Regional banks also offer another thing that's much prized these days on Wall Street: relatively easy-to-read balance sheets.

For instance, Ohio-based Fifth Third Bancorp's FITB most recent 30-page quarterly report contained just 11 explanatory footnotes and two references to special purposes entities -- the much-maligned off balance sheet financing vehicles that banks and other companies use to limit their exposure to loans, debts or troubled assets. By contrast, J.P. Morgan's 65-page quarterly filing includes 19 footnotes to the bank's balance sheet and a two-page discussion of its use of SPEs.

But with so many regional banks' stocks trading higher this year, it's tough for investors to find outright bargains.

Commerce Bank, the regional bank that everyone on Wall Street loves -- except short-sellers -- trades at one of the loftiest price-to-earnings ratio in the entire banking sector. The bank's stock changes hands at 23 times earnings for 2002, based on actual earnings for the first half of the year and Thomson Financial/First Call analyst estimates for the second half.

Fifth Third trades at a similarly pricey multiple. Using the same P/E formula, Fifth Third shares change hands at 24 times 2002 earnings. The P/Es are slightly lower for North Fork and AmSouth; both trade at 17 times earnings, but that's still not cheap by historical standards for a financial stock.

And some of the bargain-bin stocks in the regional sector come with a few nicks and scrapes.

San Francisco-based UnionBanCal UB, which is up 14% for the year and trades at 2002 multiple of 13, also is one of the few regional banks to be sitting on a potential mountain of bad loans to energy and utility companies. A recent study by Goldman Sachs found that on a percentage basis, UnionBanCal had more overdue energy loans in its portfolio than big commercial lenders like Citigroup and J.P. Morgan.

Sometimes there are good reasons why a stock trades at a bargain to its peers.