Smaller Banks Ripe for the Buying - TheStreet

Dragged down by the general malaise gripping the financial sector, some healthier regional banks are emerging as attractive acquisition targets.

Regional bank stocks have been pummeled along with the rest of the financial sector over the past year, as hedge funds short names across the board. As a result, the valuations of some extremely well-run banks have been pushed down to bargain basement prices, creating new interest among possible buyers.

"Between now and the end of the year, expect to see things happen," says Chris Whalen of Institutional Risk Analytics, a firm that is evaluating several banks for potential acquirers. "The value is compelling, if you can afford to wait."

The

KBW Regional Banking ETF

(KRE) - Get Report

is down about 35% from its 52-week high, even though some of the banks in the index are in excellent shape.

Sterling Bank

(STL) - Get Report

has limited exposure to residential mortgages and has paid dividends for 62 years. Then there's

Webster Financial

(WBS) - Get Report

, which has tumbled 52% for the last 12 months. Both of these banks operate in the northeast and have been spared some of the pain that other regions have faced.

Whalen said he has signed on four new clients to value banks for them. His company takes information directly from the Federal Deposit Insurance Corp. and applies various financial metrics in order to determine the health of a bank called the FDIC/IRA Bank Monitor.

Smaller regional banks have managed to capture a great deal of business as the larger nationwide banks have pulled back credit. The big banks have been distracted with losses from bad residential loans, risky collateralized debt obligations and legal pressure from state and federal authorities on sales of auction rate securities. Meanwhile, businesses continue to need capital and have turned to their local lenders for help.

The community banks are familiar with the businesses and are doing business with their friends and neighbors. As a result, loan quality tends to be better and these "good loans" form the backbone of any bank. It's what the bank depends on for income.

Despite the emerging opportunities seen by analysts, M&A activity in the sector has been slow amid the credit crisis.

The Bank of Tokyo-Mitsubishi UFJ

last month

bought out

the remaining 35% stake of

UnionBanCal

( UB) it didn't already own for $3.5 billion.

Valley National Bancorp

(VLY) - Get Report

also bought

Greater Community Bancorp

in March.

In a note Thursday, Ladenburg Thalmann analyst Richard Bove speculated that

BB&T

(BBT) - Get Report

CEO John Allison's plans to

retire

could make a deal with another regional like

Fifth Third Bancorp

(FITB) - Get Report

more likely.

Private-equity players also have been kicking the tires of many regionals, but are hampered by regulatory requirements that allow only individuals or bank holding companies to control a bank. Thus, while private equity funds like

TPG

and

Corsair Capital

have invested in

Washington Mutual

(WM) - Get Report

and

National City

( NCC), respectively, they can only buy minority stakes.

Anton Schutz, who manages two Burnham Financial Funds, says he believes more private equity funds will create bank holding subsidiaries to get around this restriction. He points out that the best areas for banks are in Texas and the northeast. The weak geographic regions, no surprise, are California, Florida, Nevada, Arizona and Michigan. But Schutz thinks there's hope for the troubled banks.

"Private equity is looking for broken names, especially the funds that want big returns," he says. "They want to fix these banks up and then sell them for a nice profit."

Schultz says the conservative money that is looking for the strong bank with the weak valuation will "pay off, just not very big."

Morgan Keegan Senior Bank Analyst Bob Patten in July told

TheStreet.com

that banks in poor housing markets like Florida

could bounce back in a few years

. But M&A would remain challenging until potential buyers were more comfortable with the credit market, he added.

" 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?" he asked.