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Turning Choosy on Banks

Not every financial stock gets crushed in the early stage of a tightening.

It's time to stop all the hand-wringing over the impact of rising interest rates on financial stocks.


Federal Reserve

on Tuesday did exactly what most people expected, signaling that the first rate hike in three years is just around the corner. In the coming days, as Wall Street debates the Fed announcement, don't be surprised if bank and brokerage stocks continue their monthlong swoon, especially if the April jobs report comes in better than expected.

But a shrewd investor will resist Wall Street's inevitable lemming-like response to sell financial stocks of every stripe and instead will look for some bargains.

That's because even if the Fed moves gradually in raising interest rates, as most expect it will, the negative impact of a rate hike is already baked into the price of most financial stocks. Since early March, the Philadelphia KBW Bank Index has fallen 6%, while the Amex Broker Dealer Index is down 12%.

In fact, a slight rise in rates would be a welcome relief to most banks, which have seen their net interest margins squeezed by historically low interest rates. Low rates have reduced the profitability of banks' lending operations, because banks have little room to arbitrage the difference between their own borrowing costs and the interest rates they can charge borrowers.

While a rise in interest rates may be bad news for financial stocks in the short term, it could actually add to some firms' earnings. Higher earnings could come back as enhanced dividends, particularly as executives watch the yield spread between their stocks and government bonds widen appreciably.

"Many financial stocks are fairly valued now," says Michael Stead, a portfolio manager with Wells Capital Management who runs a financial services mutual fund.

Six weeks ago, in preparation for a run on bank stocks, Stead raised his cash holdings to 10%, the maximum amount allowed under his fund's prospectus. But now he's ready to put some of that money back to work.

The money manager, who is prohibited from discussing particular stocks, says he's eyeing financial stocks that pay solid dividends. That's because even though Stead says another drop in financial stocks is unwarranted, he expects most of them to tread water for the next several months.

Stead's also focusing on banks that issue more adjustable rate mortgages than the fixed-rate variety. With the 30-year fixed-rate mortgage already pushing above 6%, Stead expects a surge in demand for adjustable-rate mortgages, because the interest rates are much lower in the early years.

California-based thrift

Golden West


comes about as close as any bank to a being a pure-play adjustable-rate mortgage lender. The savings and loan all but eschews the fixed-rate mortgage market. Almost all of the mortgages it issues are ARMs.

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Investors also may want to avoid stocks of financial firms that are overly sensitive to interest rate swings, including ones with hefty portfolios of mortgage-backed securities, such as New Jersey's

Commerce Bank

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. Rising interest rates tend to reduce the value of those investments.

David Hendler, an analyst with CreditSights, is worried that some banks, despite the Fed's telegraphing of its next move, may not be prepared for a rising rate environment. He worries that some financial firms did not take the proper steps to hedge themselves against the impact of rate hikes on their investment portfolios. And now it may be too late for them to do anything about it.

"There is a lot of risk-management hubris out there," says Hendler. "Banks have gotten fat and overly confident their ability to make offsetting trades."

Some of the banks Hendler says may be ill-prepared for a rising rate environment include


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Huntington Bancshares

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Hendler says that with regard to hedging interest rate exposure, he is most confident in

Wells Fargo

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The time to buy or sell the financials as a block has passed. It's time for investors to put on their stock-picking caps.