Bank M&As' Stealth Renaissance

The number and value of deals have skyrocketed, and the implications for stocks are bullish.
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The acquisition by

Bank of America

(BAC) - Get Report

of

FleetBoston

(FBF)

earlier this week highlights a growing trend in the financial sector this year: merger mania.

Interest in the financial arena has grown steadily in 2003, with a slew of M&A deals being announced and a plethora of financial IPOs coming to market.

"We think this is the beginning of a cyclical upturn in the market, and financial stocks tend to lead that," said Kathy Smith, portfolio manager of the Renaissance Capital IPO Plus Fund.

Within the commercial banking sector, about 162 mergers have been announced so far this year and 223 deals have been reported in the insurance sector, according to Thomson Financial.

While the numbers aren't as impressive as they were in the late 1990s, they're certainly better than last year, and the value of the deals is also significantly higher. M&A transactions within commercial banking and insurance have amounted to $60.3 billion and $46.8 billion, respectively, so far. At this time last year, banking deals totaled $7.7 billion and insurance deals amounted to $7 billion.

"M&A activity is still pretty soft compared to 1998 and 1999," said D.A. Davidson analyst Jim Bradshaw. "But valuations have gone up

recently so I do think there's increased interest from sellers and there are a lot of buyers around."

Analysts say the agreement between Bank of America and Fleet on Monday will likely spark a round of mergers, as big players like

Citigroup

(C) - Get Report

look to snap up regional banks like

KeyCorp

(KEY) - Get Report

and

PNC Financial

(PNC) - Get Report

.

Just as commercial demand for financial companies has been strong, so too has investor demand. Almost 30% of the IPOs this year have come from the financial sector, and the returns have exceeded those of other public offerings so far, according to Renaissance Capital.

Accredited Home

(LEND) - Get Report

, which sells mortgages, is up 261% since going public in February, while

Infinity Property & Casualty

(IPCC)

, a provider of auto insurance, has climbed 101% since its debut.

CapitalSource

(CSE)

, a commercial lender, has gained 52% so far.

Financial IPOs have returned more than 60% on average this year, and companies are lining up to get a piece of the action. Retail banker

Franklin Bank Corp.

, bank holding company

Coast Financial

and mortgage firm

Luminent Mortgage Capital

all have registered to go public this year, as have insurance companies

American Equity Investment Life

,

Assurant

and

United National Group

.

Michael Rebello, a professor of finance at Georgia State University, said the financial sector has been so popular because investors realize it is one of the first beneficiaries of a turnaround in the economy.

"When the economy improves, the demand for loans increases, margins expand and credit quality improves," he said. "There are fewer bankruptcies and that helps balance sheets."

Consumer demand for loans was strong in the third quarter, and many companies reported improved credit metrics. The financial sector posted earnings growth of 28% in the quarter, and analysts expect profits to grow 45% in the fourth quarter.

"Banks earned a surprisingly strong amount of money over the past year, given how weak the economy was," said D.A. Davidson's Bradshaw. "As we pull out of this malaise, the expectation is that earnings will accelerate even further for this group."

Still, some analysts caution that the sudden interest in financial firms could wane going forward. "It does not signal the all-clear for this sector," said David Menlow, an analyst at IPO Financial.

Despite signs of a recovery, financial companies continued to report weak commercial-loan demand in the third quarter and net interest margins contracted. In addition, while earnings are expected to be good in the next couple of quarters, analysts warn that much of the good news already has been factored into share prices, which have run up sharply this year.

"If the pace of growth is slow," said Bradshaw, "we may be headed for a fall."