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Stock Strategist Industry Reports

Regional Banking Is Back

A few regional banks are set to rise from the rubble as winners of this banking crisis.

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Warren Buffett once quipped that when the tide goes out, you discover who has been swimming naked. At first glance, the banking sector now looks like a nudist beach. But if you look closer, you'll discover that a few regional banks didn't forget to put on their swimsuits.

Regional Banks, Securitizations, and Subprime Lending
Regional banking was always a competitive field, but its fortunes took a negative turn a few decades ago with the surge of securitizations. Gradually old-school regional bankers found themselves competing with investors in the multi-trillion-dollar fixed-income market and their enablers on Wall Street. The regional banker who used to personally know his borrowers and manually underwrite loans had no chance against the Street's well-oiled sales machine that was both flush with cash and ready to gobble up anything that it could package as a security and resell to yield-hungry investors.

In order to maintain their relevance and profitability, regional banks had to either cater to more marginal clients (read: subprime) or find a new gig, which led them to focus on less-homogenous products such as commercial real estate, construction, and loans to local businesses. For many years, this strategy worked well because the rise in real estate prices and relatively buoyant economy obscured the risks that were building up on their balance sheets. Although competition from super-regional banks and Wall Street was tough, regional banks could still grow by a very nice clip, report only minimal loan losses, and boast an eye-popping return on equity. Life was great--or at least it seemed to be.

Then the credit bubble burst and real estate prices collapsed. Regional banks suddenly faced a new reality: slowing growth and escalating loan losses that threatened their survival. This triggered a wave of bank failures. Since January 2008, the FDIC has closed over 30 regional banks, and we expect many more failures in 2009. The table below includes a few examples of banks that have a question mark hanging over their future. If current credit trends persist for a few more quarters, without raising more capital, failure is a possible outcome for these banks.

 

The Winners
Unfortunately, banks usually behave like a herd and most bankers don't like to stand out from the crowd. As Chuck Prince, the former CEO of the beleaguered  Citigroup (C) put it: "as long as the music is playing, you have to keep dancing." Well, Chuck, during the boom years a few regional banks refused to dance because they didn't like the music. Now, when everyone else is suffering from a terrible hangover, a few winners are getting ready for their dance.

Out of 51 regional banks that we cover, we identify only seven that have good chances of becoming big winners of the current banking crisis. What's unique about this group? Unlike their competitors, they haven't lost their religion: old-school banking. These banks hardly grew during the past five years because they didn't find it that profitable. Those who did find growth opportunities used core deposits to fund them, as oppose to the unstable, nonsticky funding sources commonly used by peers that evaporated overnight or became extremely expensive when things turned south. These banks tend to be low-cost providers, but they still provide good customer service. Since they don't typically compete on price and don't chase loan volume, servicing their customers well is their mantra. Most important, these banks have solid understanding of risk and self-discipline. When the herd of banks was loading up balance sheets with toxic assets, the winners stayed put.

 

What's Next
Today, the CEOs of these banks are tap-dancing their way to work. With Wall Street in disarray, big money center banks one-step away from nationalization, and many small irrational competitors six feet under or on their way there, the competitive landscape looks brighter then ever. After years of being the victims of competitors' irrational behavior, they are now ready to take on a new, more adventurous role: vultures. In this capacity, they will sift through the rubble of failed banks to cherry-pick assets, deposits, and branches that fit their needs. One good example is the recent transaction of  WestAmerica (WABC), which bought the assets of the failed County Bank from the FDIC. We expect to see more of these kinds of deals in 2009.

In addition to acquisitions, the winners are also likely to grow organically in 2009 but still be conservative in their expansion. How will they accomplish it? By raiding the most profitable clients of their weakest competitors. Growth won't be at a neck-breaking rate, but it will be extremely profitable.

The sun is shining again on a few regional banks.

Michael Kon has a position in the following securities mentioned above: BBX. Find out about Morningstar’s editorial policies.