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Downgrade Hits Key

Merrill cuts ratings on three big banks.

Merrill Lynch


downgraded three banks.

Analyst Ed Najarian lowered

Wells Fargo

(WFC) - Get Free Report

to neutral from buy and


(KEY) - Get Free Report


Regions Financial

(RF) - Get Free Report

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


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






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.

Loan losses aside, Regions also has exposure to the capital markets business through its subsidiary, Morgan Keegan, which is also likely to have lower earnings.

Large Wall Street brokerage firms, which reported third-quarter earnings earlier this week, saw significant losses in their fixed-income businesses as a result of lower securitization revenue on mortgage-related securities and lower LBO commitments from this summer's credit market turmoil.

"Approximately 17% of Morgan Keegan's

first half '07 revenue was derived from fixed-income capital markets, which could be materially weak" in the second half of this year," Najarian writes. "Moreover, a meaningful chunk of Morgan Keegan's 'trading and other' revenue is probably trading-related and could also decline materially."

Shares of Wells Fargo slipped 10 cents to $36.45. Key fell 40 cents to $33.78, while Regions' shares dropped 52 cents to $30.87.