'Decent' Loan Growth Best Feature of Regional Banks' Q3 Earnings

NEW YORK ( TheStreet) -- For investors following U.S. bank stocks, the most positive aspect of third-quarter earnings season has been strong growth in commercial and industrial loans for several key regional players.

It was a mediocre quarter overall, without much excitement when it came to upward revisions of sell-side earnings estimates. "Including the universal banks (BAC, C, JPM), consensus EPS estimates for '14 for large/midcaps decreased 0.5% on average through earnings season. Ex. the universals, estimates decreased 0.4%," according to Jefferies analyst Ken Usdin, who summed up third-quarter industry results in a client note late Friday.

JPMorgan Chase ( JPM) made the biggest splash this earnings season, with a $387 million net loss, as the company set aside $9.15 billion for litigation reserves during the third quarter. The bank also surprised investors by actually reporting it had $23 billion in litigation reserves on its "fortress balance sheet," the term repeatedly used by JPMorgan CEO James Dimon.

JPMorgan is expected to enter settlements with the Justice Department and regulators covering criminal and civil investigations of the company's securitization of mortgage loans, as well as other mortgage-related areas. The total settlement cost to the company could be as high as $13 billion, according to various media reports. The first part of the big round of settlements was announced Friday, with the Federal Housing Finance Agency (FHFA) -- which regulates Fannie Mae ( FNMA) and Freddie Mac ( FMCC) -- announcing a $5.1 billion agreement.

Mortgage Blues

Aside from the continually unfolding JPMorgan saga, the biggest trend for the banking industry in the third quarter was the tremendous decline in mortgage loan refinancing activity, along with a decline in gain-on-sale spreads, as a result of rising long-term interest rates. "Mortgage production fee revenues nearly halved Q-Q as originations dropped 20% and gain-on-sale margins declined 30%," Usdin wrote, adding "We expect another 20% reset in production fees in 4Q as origination volumes reset lower again."

Usdin is not thrilled with prospects for improving noninterest income for the industry as a whole: "There is not a ton of momentum in most other fee income categories, and we believe tough mortgage banking comps will limit overall '14 fee growth to a few percentage points," he wrote.

Credit Leverage

Over the past few years, the banks have been in recovery mode, with continual earnings improvement as the industry works through problem loans, focuses on cost-cutting, and enjoys "credit leverage," with declining credit costs and the release of loan loss reserves boosting earnings.

"Net charge-offs showed meaningful improvement again this quarter and now sit at 28bp of loans for the average bank," Usdin wrote. A common measure for earnings quality is the annualized ratio of net charge-offs to average loans. A ratio below 1% is typically considered "good," although specialized banks focusing on credit card loans will see considerably higher net charge-off ratios.

That net charge-off ratio of 28 basis points cited by Usdin is very low, and indicative of the generally weak loan demand in the United States and a lack of "seasoning," for the strong wave of new commercial and industrial loans over the past two years.

According to Usdin, loan loss reserves on average covered 1.5% of total loans at the end of the third quarter, "which is pretty close to the pre-cycle average." That's a high level of coverage relative to the current net charge-off rate. Usdin sees the banks continuing to see an earnings boost from reserve releases, since "Most leading indicators (nonperformers, inflows, early-stage delinquencies) are still improving."

Accentuate the Positive: Loan Growth

With banks continuing to face pressure on their net interest margins, along with the continued mortgage finance decline and prospects for continued weakness in trading revenue for the largest players, the industry is sure to continue its focus on lowering expenses, with more layoffs being the unfortunate result. Investors may wish to focus regional names seeing success in growing non-real estate commercial and industrial (C&I) loans.

Among large regional names, Fifth Third Bancorp ( FITB) of Cincinnati saw sequential growth in average C&I loans of just 1% during the third quarter, but loans of this coveted type were up 15% year-over-year. The company also saw the largest year-over-year growth in revenue-per-share among large-cap banks, despite a 40% drop in mortgage revenue, according to KBW.

KeyCorp ( K) of Cleveland reported C&I loan growth of 2% quarter-over-quarter and 11% year-over-year. The company also said it had met its efficiency improvement goals.

While the company cannot be considered a regional bank because of its focus on credit card lending, Capital One reported very strong sequential growth average in C&I loans of 5% to $41.6 billion during the third quarter. Capital One's stock closed at $70.38 Friday. The shares trade for 10.1 times the consensus 2014 earnings estimate of $6.95, among analysts polled by Thomson Reuters. That's a cheap valuation when you consider Capital One's third-quarter return on tangible equity of 18%.

U.S. Bancorp ( USB) of Minneapolis reported average commercial loan growth of 2.2% sequentially and 13.5% year-over-year, to $62.9 billion in the third quarter. The company continued to be one of the strongest overall performers among the top 10 U.S. banks, with a third-quarter return on average common equity of 15.8%. Please see TheStreet's earnings coverage for more on USB's third-quarter results.

Fastest Loan Growth

Investors looking for the fastest loan growth need to focus on smaller regional names. Here are the "top three organic growers" during the third quarter, according to Usdin:

Signature Bank ( SBNY) of New York saw its average total commercial loans and leases grow 8% sequentially and 40% year-over-year, to $11.2 billion in the third quarter. The company is focusing on quickly expanding its national equipment leasing business.

Signature Bank's third-quarter return on average equity (ROA) was 13.77%, increasing from 12.08% a year earlier. Jefferies analyst Casey Haire rates the bank a "buy," with a $117 price target, representing 13% upside potential from Friday's closing price of $103.26.

Texas Capital BancShares ( TCBI) of Dallas reported average portfolio loans of $7.7 billion during the third quarter, growing 8% from the previous quarter and 21% form a year earlier. The company is a mortgage warehouse lender, but most of its portfolio loans are business loans. Texas Capital reported a third-quarter return on average common equity of 13.74%. Jefferies analyst Emlen Harmon rates TCBI a "buy," with a price target of $57.00. The shares closed Friday at $53.77.

Among the fastest growing banks, First Republic Bank ( FRC) of San Francisco stands out, because it focuses on a national jumbo mortgage lending business. The bank reported average loans of $31.4 billion during the third quarter, growing 6% from the second quarter and 18% year-over-year. First Republic's third-quarter return on average common equity was 12.72%. Haire rates First Republic a "hold," with a $50 price target, and wrote in a client note on Oct. 16 that the bank trades at "a premium to peers," which is "deserved given FRC's growth trajectory." First Republic's stock closed Friday at $50.97.

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-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.