Pent-Up Shorts Ravage Regional Banks

Regional bank stocks took a nosedive on Thursday as the short-selling ban was lifted and pessimistic comments regarding the sector continued to hang in the air.

The Keefe Bruyette Regional Bank index slumped nearly 7% to 58.22, while the NYSE Financial Sector index fell 3.5% to 4703.51 on Thursday, after the ban on short sales for more than 800 financial companies put in place Securities and Exchange Commission expired at midnight Wednesday. The SEC extended the ban on short selling to Oct. 17, but the ban's deadline was moved up to yesterday after President Bush signed the Emergency Economic Stabilization Act last week.

The New York Times also reported that the Treasury Department is considering taking equity stakes in U.S. banks to re-instill confidence in the financial system.

"The market seems to be differentiating between the companies that have capital and have gotten capital and those that have not yet gotten it and need it," says Matt Shields, a bank stock trader at FIG Partners in Atlanta. "The shorts have been biting their chops here."

Shares of KeyCorp ( KEY) were falling 18%, Fifth Third Bancorp ( FITB) was dropping 11%, Regions Financial ( RF) were off 14% and Sovereign Bancorp ( SOV) plunged 18%. On the other hand large-cap bank stocks such as Bank of America ( BAC) and JPMorgan Chase ( JPM), as well as the trust banks including Bank of New York Mellon ( BK), Northern Trust ( NTRS) and State Street ( STT) were all in the black for the most part Thursday.

Regional bank stocks were under additional pressure, after Friedman Billings Ramsey published an industry note this morning suggesting that commercial loan losses are expected to accelerate and "potentially exceed, historical peak losses over the coming quarters."

"Commercial credit continues to deteriorate, and, while regional banks are still experiencing relatively low loss levels in their commercial and industrial portfolios ... Management teams have shifted from being optimistic to cautiously optimistic about commercial credit," the note says.

Friedman Billings suggests that Comerica ( CMA), City National ( CYN), Webster Financial ( WBS), UCBH ( UCBH) and Sovereign remain among those banks with the highest risk related to business loans.

"Compounding potential credit problems is the current liquidity crisis, which is making it harder for businesses to fund their operations, therefore decreasing the likelihood that many businesses will be able to earn their way out of the current down cycle," the analysts write. "Ultimately, we believe that the contrails of a consumer (or consumer-related) recession have yet to be seen fully in commercial credit, preventing us from becoming more bullish on banks at current valuations."

The M&A trend has picked up amongst the largest banks as investors become increasingly nervous about which companies may not make it through the credit crisis.

Citigroup ( C) and Wells Fargo ( WFC) are locked in a legal battle over the ownership of Wachovia ( WB). Both sides agreed to take a break from the legal spats -- extended until Friday -- so that the two companies, along with the Federal Reserve, can come to a resolution. The Wall Street Journal says the two banks were hung up on certain key issues pertaining to how exactly the Charlotte, N.C., lender would be carved up and how much in bad loans it actually has on its books.

One bright spot in the sector was National City ( NCC). The stock was up as much as 26% earlier in the day as rumors became clearer that the Cleveland bank is looking to find a buyer. The Wall Street Journal reported on Thursday that PNC Financial Services ( PNC) and Bank of Nova Scotia were considering making offers.

Analysts have been fairly positive on Nat City lately, despite its significant exposure to subprime mortgages and brokered-home equity loans. Several analysts upgraded the stock on Sept. 26 -- the day after Washington Mutual failed and was subsequently bought by JPMorgan Chase -- on the basis that Nat City does indeed have sufficient capital.

But as the liquidity crisis rears its ugly head once more in the banking sector, even banks with a fair amount of capital such as Nat City have been scrambling to find a buyer. The company had tried without success to find a buyer this spring. Instead it ended up raising $7 billion from a group of investors led by Corsair Capital.

Shields said the rumors that Nat City is looking to sell itself has been "one of the worst kept secrets" over the past few weeks.

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