Regional Banks: It's All About Credit

The slumping housing market and lingering credit crunch have pummeled financial stocks over the past year to lows not seen in almost two decades. Last year, banks were feeling the pinch from writedowns related to securities backed by mortgages and unsold leveraged loans. This year, banks are getting socked in the stomach as a consumer-led recession results in the rapid deterioration in credit beyond just residential mortgages to creep into other consumer and commercial-related loans, such as credit cards and residential construction loans.

As a broad swath of banks and consumer finance companies begin to report second-quarter earnings results next week, profits -- if any -- will continue to be weak. Banks will be busy continuing to add to their pile of loan loss reserves, marking down leftover leveraged loans and mortgage-backed securities, and shoring up capital wherever they can, likely in the form of dividend cuts.

This week, TheStreet.com asked several high-profile equity analysts about how the credit crisis is affecting banks and other consumer finance businesses. In this installment, Morgan Keegan Senior Bank Analyst Bob Patten gives his take on how regional banks are faring.

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TheStreet.com: What are the fundamental differences between the regional banks and the large universal banks? How has that helped and hindered them as the housing and credit crisis unfolded?

Patten: It's really about earnings and geographic diversification. The smaller the bank, the more plain vanilla the operations -- loans and deposits, very little fee-income -- so in an environment where banks are shrinking their balance sheets to preserve capital and their increasing their loan loss reserves to deal with troubled debt, the smaller banks have less options to them. They also have [fewer] options for capital if they need it. So my concern is in the smaller capitalization bank-land. They're dealing with the same issues that all the big banks are, which are real estate and stressed markets.

It's not as much the fundamentals as it is the macros overriding this group. It's all about credit; it's all about provisions and nonperforming asset growth on the banks' balance sheets. It then comes back to capital adequacy and the ability of the banks to move this stuff off the balance sheets through loan sales and taking charge-offs.

Right now, the market has put bank valuations down near tangible book value for the majority of the group -- and even some banks at significant discounts to tangible book. That tells investors that they don't believe that banks have taken the hits to their balance sheets that they needed to take. My view is the banks are getting caught up as fast as they can. People forget that banks operate under accrual accounting, which means as events occur, they accrue for loan-loss provisions. ... They can't just create pool of money and charge off loans all at one time. So this is a process. This is a cycle and the banks are working through it. Obviously there has been a huge negative sentiment overriding this group.