Regional Banks: It's All About Credit - TheStreet

Regional Banks: It's All About Credit

In <I>TheStreet.com's</I> second Q&A with bank analysts, Morgan Keegan's Bob Patten says macro factors are overriding fundamentals for regional banks, making some of them 'absolute steals.'
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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.

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.

Loan losses have been at the forefront of the news reports these days. What asset classes are most concerning for the regional banks?

Lot loans, constructions loans, second-lien home equity, especially brokered home equity and second-lien home equity in vacation or stressed markets.

Those markets that were the growth markets are now the stress markets. There was a lot of leverage in the system that is being unwound in terms of housing and borrowing on housing. We think that ... Florida and California,

as well as Nevada, Arizona, the Midwest and other rising unemployment areas will take several more quarters, if not two more years, to recover.

The issue is when the banks finally foreclose, they start putting

real estate back on the market. That's going to have a negative impact, because you're dumping more inventory at lower prices back onto the market. So it's going to be a cycle. It's got to work through. What we haven't seen yet are the vulture funds coming in with higher bids. They're still very aggressive in terms of their

low bid for for properties from the banks. We're looking at nonperforming assets growing on an absolute basis with very little loan sales and recoveries coming in to mitigate

nonperforming assets and charge-off growth. When we start to see loan sales happen that will start to be the beginning of declines slowing of the growth of nonperforming assets. We haven't seen it yet, but there is a lot of liquidity out there on the sidelines.

What are your initial earnings expectations for the second quarter? Which issues will investors be focusing on the most?

I am expecting the banks to rally into earnings at this point. If you asked me to make a trading call I would be buying the banks here, going in, because I think the short interest is excessive and the bad news is in there. If the banks come out with anything in terms of earnings that is less bad you could see a pretty good rally. Now does that hold over the long term? I think at some point the negativity will come back in this group, because the recognition is we still have another couple quarters to get through, but the banks are getting closer to giving the market some comfort. They at least know where the problems are and are dealing with them. So we will have spots -- names that investors will be able to pick better -- after this quarter in terms of owning some financial exposure.

Investors want to make sure banks have enough capital. Conserving capital and building loan loss reserves and starting to remediate loans off the balance sheet are key priorities, along with restoring investor confidence and management credibility because right now it's at the bottom of the barrel. Management has done it to themselves, but I went back to the last credit cycle -- it was the same thing. Everybody thought the world was ending. We're at the bottom of the cycle again, saying the world's ending and everybody's capitulating and selling everything and going short and at some point this group is going to get overdone. The pendulum in my view is swinging over to the other side.

One large reason why investors have flocked to bank stocks is because of the dividend story, but banks are now in capital preservation mode. Should we expect to see more cuts to banks' dividends as second-quarter results are reported? Which regional banks are most at risk?

Absolutely. I think the issue here is that the banks need to conserve capital. That's the No.1 priority, because it's all about safety and soundness and building credibility. Cutting the dividend for a short term -- and letting investors know that this is a difficult environment and that the banks will get through this is what they need to do.

Some banks

are likely to cut the dividend where the payout ratio is high, such as

Synovus

(SNV) - Get Report

,

Comerica

(CMA) - Get Report

,

SunTrust

(STI) - Get Report

and

Wachovia

(WB) - Get Report

-- again. There are banks that could go to stock dividends, such as

First Horizon

(FHN) - Get Report

did last quarter.

Colonial Bancgroup

(CNB)

could be a bank that goes to a stock dividend.

What about other forms of capital raises? Who is most in need?

SunTrust and Wachovia are at the top of my list. I don't think either one is out of the woods, even though SunTrust did come out and say they didn't need it. My concern is that SunTrust has just got a lot of

exposure in Florida, just like the other banks. And they've been a little late to the party, they're lightly reserved at 1.31% percentage of total loans and even if they did take a significant reserve build, if you added $750 million to the reserve -- that's the most they could have without showing a loss for the quarter -- you build it to 1.71%

of loans. That's still at the light side.

You have some banks

at 2.20%

of loans.

Bank of America

(BAC) - Get Report

is at 2.15%. So I think there is still a significant amount of reserve building that still needs to be done and credit will go as credit goes. And if they start to show default issues and it starts to get worse, you don't want to have to raise capital a couple quarters from now. The cost of capital is increasing daily.

Why haven't we seen more M&A at the regional bank level? Who could be a hot target?

M&A just doesn't happen in a credit cycle. The simple fact is if you're having a hard time figuring out what your problems are on your own balance sheet, why would you want to buy somebody else's?

I still think you go back to the franchise values of the markets they are in. Florida is the bear story today, but at some point, if you look out the windows in Florida, you've got palm trees and ocean and it's a nice place to live. Do you want to live there or in Oklahoma? My thought is it's a huge asset-gathering market. With the rising cost of capital, banks will be much more judicious about how they allocate when they use capital, in terms of returns. Things like asset management will be a big driver of fee revenues. You want to be where the retirement markets are, so I think Florida will come back in a few years. Franchises like Colonial, SunTrust, First Horizon, which border all those southeastern states; franchises like the Texas banks. You can't rule out names like

KeyCorp

(KEY) - Get Report

and

Fifth Third

(FITB) - Get Report

for M&A, but ... they're in the Midwest and slower growth

makes them not as much of an attraction. Synovus could be an interesting play a year or two from now. It's a great little bank.

How will we know when we've hit the bottom in bank stocks?

When the rate of increase of nonperforming assets begins to slow. Right now we have a 17% increase from quarter to quarter. When that slows to 10%, that's a very good sign. That can happen two ways -- if housing prices stabilize and things start to get better in the real estate market, or if the banks start to sell loans off the balance sheet.

What is your top pick?

First Horizon. It's got one of the strongest capital

levels ... of any of its peer group. It's finally announced the sale of the mortgage company, which frees up another $400 million in capital and reduces the balance sheet exposure by about $5 billion to $6 billion over the next year. They're doing everything they said they were. I think it's a steal. Fifth Third also looks interesting here. I think the embedded value of the processing company is not showing up in the company's current valuation. I think Colonial also. Anybody who looks back a year from now will wish they bought this thing at $5 a share. It's not going to zero.