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'Storm Is Brewing' for Banks

NEW YORK ( TheStreet) -- A net interest margin storm is brewing for regional banks, according to JPMorgan Chase analyst Steven Alexopoulos.

JPMorgan on Tuesday established 2013 price targets for most of the 27 mid-cap banks covered by the firm, and while Alexopoulos said "we see sector upside from current levels in the 13% range through YE 2013," which he termed "a decent level of return," the analyst also said that "given the risks of QE3, and the likely further flattening of the yield curve tied to such an action, we would be locking in profits at current valuation levels."

"QE3" refers to another possible round quantitative easing through long-term Treasury securities purchases by the Federal Reserve, in an effort to bring long-term rates down further, in order to spur economic growth.

With the benchmark federal funds rate in a range of zero to 0.24% for a prolonged period, there's a limit to how much further banks can expect their funding costs to decline. Meanwhile, with strong deposit growth, banks are continually investing in securities and new loans with ever-declining rates, pressuring net interest margins (NIM) and reducing profitability.

Alexopoulos said that since the first quarter of 2007, "the cost of interest bearing deposits for the group has declined 306 bps to only 0.55% in 1Q12," and that since "loan growth is currently positively impacting the industry's earning asset mix (from cash to loans), there appears to be enough gas in the tank to withstand meaningful NIM pressure perhaps through 2014."

JPMorgan Chase projects the median cost of deposits for mid-cap regional banks to decline to just 27 basis points in the fourth quarter of 2014, but Alexopoulos added that "a looming disconnect between falling asset yields and the industry's ability to further lower deposit costs is a recipe for a NIM storm."

Following the recent string of sluggish economic data, the analyst said "we now think it's too optimistic to assume that the Fed starts a tightening campaign in the beginning of 2014," and "assuming that the current very low level of interest rates will be here over the intermediate term and that the first rate hike is pushed out to 2015, our 2014 and 2015 EPS estimates are coming down by around 13% in each year."

According to Alexopoulos, "if the Fed were indeed to wait until 2015 to begin raising short-term rates, and then raises rates by a quarter point at each meeting of the Open Market Committee, "this would imply a more normal Fed Funds rate (of 4.25%) by YE2016," also implying that "the first year bank investors could reasonably expect a more normal level of earnings from the industry is in 2016!"

Despite that gloomy outlook, JPMorgan has "Overweight" ratings on nine of the 27 mid-cap regional banks covered by the firm. Here are Alexopoulos's two "top longs," along with two more favored "growth plays," and the analysts' two "top shorts" in the space:
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