We may be approaching the bottom of the market for financials, as mortgage players such as

IndyMac Bank

( IMB) expect problem loans to peak in late 2008.

While it may be a bit early, this is a good time to start looking for bargain bank stocks that could produce stellar returns for patient investors once the recovery begins.

Back in September, TheStreet.com Ratings looked at the bank and S&L stock components of the S&P 500, 400 MidCap and 600 SmallCap indices, and narrowed the group down to five that were attractive based on several criteria, including a price-to-book ratio below two.

On Friday we gave an

update

on the performance of the group, with three of our picks tumbling and two bringing in stellar results.

Filtering Out Candidates

The Treasury Department and the largest players in domestic mortgage servicing have been addressing the problems of subprime borrowers facing unaffordable rate resets, through the Hope Now Alliance and Project LifeLine. With the "R" word being bandied about, the Federal Reserve has made aggressive rate cuts and is likely to do more.

Starting again with the three S&P Financial Indexes, here are criteria for filtering out potential candidates for bank and S&L holding company stocks in this market:

  • Price-to-book ratio below one.
  • Nonperforming assets comprising less than 1% of total assets.
  • Loan loss reserves covering at least 100% of nonperforming loans.
  • A ratio of nonperforming loans to core capital and reserves of less than 10%.
  • Positive net income for 2007.
  • 2007 Dividend payout ratio below 100%.

We skipped the dividend yield criteria this time, but continued to exclude holding companies paying out dividends exceeding their earnings. With the real estate crisis continuing to unfold, it seems imprudent for holding companies to reduce capital at this time, in this manner.

Here are the bank and S&L holding companies that meet the new criteria:

Here's the group again, with the rest of our selection ratios and definitions:

Finally, let's take a look at capital ratios and compare 2007 earnings performance with the previous two years:

All eight institutions have weathered the housing storm well, and have plenty of reserves to cover bad loans.

We discussed

Susquehanna Bancshares

(SUSQ)

in detail last

Friday

.

Here are two more standouts that the market threw out with the bath water. Both maintained strong asset quality during 2007 and kept their earnings from falling significantly. It's interesting to note that while the media pays attention to the prospects of giant banks like

Citigroup

(C) - Get Report

,

Bank of America

(BAC) - Get Report

,

Wells Fargo

(WFC) - Get Report

and

Wachovia

(WB) - Get Report

, none of those names qualify under this criteria.

First Community Bancorp

(FCBP) - Get Report

achieved the best returns on assets for the group over the past three years, and has excellent loan quality. Nonperforming assets comprised just 0.37% of total assets as of Dec. 31, up only slightly from a year earlier. The holding company's return on average assets (ROAA) for 2007 was 1.71%, holding up very nicely in a year when most banks and thrifts saw their earnings tumble.

Returns on average equity (ROAE) have been less impressive, since the company has traditionally maintained a high level of capital. Of course, in the current environment, that's a good thing.

First Community's price-to-book ratio was 0.70 as of the market close on Feb. 29. According to Bloomberg, this ratio has averaged 1.65 over the past five years, with a high of 2.26 on Feb. 3, 2006. The company's price-to-earnings ratio (P/E) was 8.96 as of Feb. 29. This compares with an average P/E of 17.62 over the past five years.

The company's quarterly dividend of 32 cents a share translates to a current yield of 4.5%. That seems safe, considering the steady earnings and strong capital level.

First Community has maintained stellar net interest margins by focusing on commercial real estate and construction lending in the Los Angeles and San Diego areas. These loans generally have higher rates than residential loans, and also tend to adjust monthly. This makes it easier for the bank to manage interest rate risk. First Community's focus on commercial real estate and construction lending in the current environment makes their continued strength in loan quality remarkable.

While there's still risk of a surprise as the real estate crisis plays out, First Community Bancorp appears to be a bargain at such low multiples. With consistently strong earnings and asset quality and an attractive dividend yield, this stock should be a winner when the market recovers and bank stocks trade at more typical multiples.

First Niagara Financial Group

(FNFG)

is an S&L holding company operating across Upstate New York. While residential loans make up a large part of its mortgage portfolio, the company's loan mix is well diversified, with multifamily and commercial mortgages, as well as nonmortgage commercial loans and consumer loans. Total commercial loans increased 13% during 2007 and comprised 54% of total loans at the end of the year.

In a competitive market and with a lower-risk business model, First Niagara maintains narrower interest rate margins than an institution like First Community. Still, during a period of narrowing interest rate spreads, First Niagara achieved a respectable ROAA of 1.05% for 2007, down from 1.14% in 2006 and 1.18% in 2005.

While deposit rates quickly dropped following the Fed's recent rate cuts, mortgage rates have actually bumped up in the past two weeks. It would appear the interest rate environment should be much friendlier during 2008, however. CFO Mike Harrington stated during the company's fourth-quarter earnings conference call that local deposit pricing competition could cause First Niagara's net interest margin to contract during 2008.

First Niagara's loan quality remains excellent. Nonperformers make up just 0.35% of total assets, compared to 0.20% in December 2006 and 0.28% at the end of 2005. Yes, that's a 75% increase in NPA over the past year, but it's still a very low percentage. The company steered clear of subprime mortgage lending during the housing boom and has reported no significant increase in nonperforming home equity loans.

Mr. Harrington made some comforting remarks during First Niagara's Feb. 1 conference call, saying that 30% of the home equity loans were first liens. Another 25% of the home equity loans are second liens, with First Niagara also holding the first mortgage.

During 2007, First Niagara made several changes to enhance earnings. One was the sale of nine branches to Elmira Savings Bank and Legacy Bancorp. These were branches the company believed had weaker growth prospects or were outside First Niagara's desired market area. While the sales caused the company to let go of $149 million in deposits, they booked a $21 million gain on the branches sold.

On Feb. 15, 2008, First Niagara completed the acquisition of Great Lakes Bancorp, for approximately $141.9 million in cash and stock, expanding its presence in the Buffalo, N.Y., area.

First Niagara's stock seems undervalued since it trades at less than book value and has a dividend yield of 4.90%. The company repurchased seven million shares during 2007, and expects to continue repurchases in 2008.

With decent earnings performance and very strong asset quality, there is solid support for the dividend, and hope that the company will increase it again during 2008. This looks like another winning stock for long-term investors anticipating a recovery in the banking sector.

Philip W. van Doorn is senior bank analyst for TheStreet.com Ratings.