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7 Cheapest Bank Takeout Target Stocks From KBW (Update 2)

Updated with the U.S. Treasury's auction of LNB Bancorp's TARP preferred shares, and with additional comments from KBW analyst Fred Cannon about Banner Corp.

NEW YORK ( TheStreet) -- A quick look at KBW's Consolidation List for banks highlights several names trading at significant discounts to book value, providing food for thought for investors.

As the regulatory landscape continues to evolve, investors can count on continued industry consolidation as old business models get thrown out. Savings and loan associations -- or thrift institutions -- are continuing to feel great pressure as their traditional business model of "a focus on variable-rate mortgage lending, heavy concentrations in residential real estate, and limited capital regulations," is no longer viable, as the group faces the same increased capital requirements as banks, according to KBW analyst Fred Cannon.

Cannon said on Monday that because of the higher capital requirements and a change in regulation from the Office of Thrift Supervision to the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp. and the Federal Reserve, "high loan-to-deposit ratios are no longer tolerated and concentrations in residential real estate are questions."

Hudson City Bancorp (HCBK) is an example of a large thrift that has been force by regulators to restructure its balance sheet by prepaying wholesale borrowings -- with large losses from prepayment penalties -- and also cut its dividend. The company's net interest margin -- the difference between a bank or thrift's average yield on deposits and investments and its average cost for deposits and wholesale borrowings -- was pressured for several years, in the prolonged low-rate environment, because of a focus on jumbo mortgage lending.

Sterne Agee analyst Matthew Kelley late in May said that Hudson City's options included "a push into a less capital-intensive mortgage banking," focusing on quickly selling newly originated conforming mortgages" to Fannie Mae (FNMA) and Freddie Mac (FMCC) "to generate gains-on-sale," and that the company could "also be considering a move into non-residential lending (multi-family and commercial real estate)."

Kelly also sees Hudson City as a takeout target, with a "terminal value" of $8.25 a share, which is a 37% premium to Hudson City's closing price of $6.04 on Friday.

With the Federal Reserve announcing last week that its enhanced minimal capital requirements for banks would apply to all institutions with total assets of at least $500 million, there is likely to be additional pressure on many community banks -- not just thrifts -- to sell to stronger rivals, because a higher capital requirement means a lower return on equity for investors. Institutions with higher profit margins -- those with an edge from a focus on niche lending, card lending, or with strong fee-generating businesses - with have a much easier time remaining independent.

According to KBW, there are hundreds of potential targets out there, with "398 banks that have a Texas ratio of greater than 100% with total assets of $206 billion," as of March 31. The Texas Ratio is the ratio of a bank's nonperforming loans to its Tier 1 capital plus loan loss reserves. A 100% Texas ratio is a very high level of credit exposure.

The seven holding companies on KBW's bank Consolidation List trading at the lowest multiples to tangible book value include two thrifts and five commercial banks. Several of the companies still owe the federal government for bailout funds received through the Troubled Assets Relief Program, or TARP. The dividend rate on the government-held preferred shares will increase to 9.00% from 5.00% in December 2013. This huge increase in funding cost weighs heavily on share valuations and increases pressure on the management of these companies to consider various strategic options.

Here they are, ordered by ascending price-to-tangible-book valuation as of Friday's close:
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