NEW YORK ( TheStreet) -- FBR analyst Paul Miller on Monday said he was "taking a more neutral stance on the industry" following last week's dismal showing for bank stocks, but also recommended seven defensive financial stocks for investors.
Amid a slew of tepid economic reports last week, continuing uncertainty over Europe and the prolonged political and regulatory fallout from JPMorgan Chase's May 10 announcement of $2 billion in second-quarter hedge trading losses, the KBW Bank Index (I:BKX) declined 5% last week to close at 41.93 Friday. The index is now up 6% year-to-date, but has fallen 17% from its closing high of 50.26 on March 26.
Since the market "bias has shifted to the downside in the near term as rates continue to fall," Miller said he would "remain on the sidelines with banks whose earnings are sensitive to falling asset yields and lack significant contribution from fee-based businesses."
With long-term rates at historical lows -- U.S Treasury 10-year bonds were yielding less than 1.50% on Friday -- and with most banks nearing the point where their funding costs can't decline any further, FBR expects "accelerated and meaningful net interest margin (NIM) compression," pressuring earnings "in the near time for most financials."Miller said the difficult operating environment leading to an earnings decline "could push the industry into the long-awaited merger boom. The main barrier to a robust M&A market thus far has been a wide bid/ask spread, and a prolonged path to recovery may shrink the delta as sellers moderate expectations." In light of strong refinancing volume -- driven in part by President Obama's expansion of the Home Affordable Refinance Program, or HARP 2.0, which allows borrowers with mortgages held by Fannie Mae (FNMA) or Freddie Mac (FMCC) to refinance their homes at today's historically low rates, even if the decline in property values over the past several years left their homes worth much less than the loan being refinanced -- Miller said that mortgage loan "origination volumes remain robust and should drive another few quarters of strong mortgage banking revenue." While saying that strong mortgage fee revenue would "not be enough to offset the impact of a deteriorating economic environment and depressed asset yields on many institutions," Miller said that lenders with "significant servicing and origination exposure will be better protected from these negative effects and will outperform the group." Miller recommended four financial names that are well-positioned with strong mortgage origination and mortgage servicing businesses benefitting from "the pullback of major players," including Bank of America and Ally Financial, while also highlighting three "company-specific opportunities among other regional banks." All seven companies are rated "Outperform" by FBR. Here are FBR's seven defensive financial stock picks, beginning with the mortgage lenders: