Downgrade Hits Key

Merrill Lynch(MER Quote) downgraded three banks.

Analyst Ed Najarian lowered Wells Fargo(WFC Quote) to neutral from buy and KeyCorp(KEY Quote) and Regions Financial(RF Quote) to sell from neutral.

In an industry note, Najarian says the already-weak credit cycle is likely to get worse into 2008. He says stock market gains from the Fed's recent interest-rate cut will be short-lived.

"The positive impact of a Fed easing cycle will be more than offset by higher than anticipated credit losses and loan loss provisions," Najarian writes.

Despite Wells Fargo's conservative lending and a risk-averse loan underwriting, Najarian still expects net charge-offs to rise materially.

"Credit losses in conforming and subprime mortgages, home equity loans and commercial real estate and construction loans will rise considerably" this year and in 2008, Najarian writes. He says valuation played a key role in his downgrade.

While Key has done a good job of exiting high-risk consumer loan businesses -- it sold subprime lender Champion Mortgage to Fortress (FIG Quote) and HSBC (HBC Quote) last year -- Najarian is still concerned that the Cleveland bank has not provisioned enough to protect itself against future loan losses. He also expects that losses in the company's commercial real estate portfolio should increase from "abnormally low levels."

"In our assessment Key appears the most vulnerable among the large regional banks to weak EPS growth stemming from 'credit normalization,'" he writes.

Amid the further backdrop of a deteriorating Midwest economy, Key will also be crimped by lower principal investing gains and commercial mortgage-backed securities securitizations and additional "modestly dilutive" small and mid-sized bank acquisitions, Najarian writes.