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Quarter-End Insights

Our Outlook for Bank Stocks

The pressure to repay TARP moves down to regional banks.

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With the end of the year and Ken Lewis' retirement rapidly approaching,  Bank of America's (BAC) CEO search seemed a little desperate. Compensation restrictions that are part of the government's TARP program, especially those rules put in place by Special Master (aka "Pay Czar") Kenneth Feinberg, were hampering the search. BofA's desire to get off of government support was surely increased by these factors, and after some quick negotiations and $20 billion from new shareholders, the firm was out of TARP. 

This in turn put significant pressure on the two remaining large TARP recipients in BofA's peer group,  Citigroup (C) and  Wells Fargo (WFC). It took but one week (and $30 billion of additional capital) for these two institutions to pay back TARP as well. Shareholders were diluted, especially Citi's, but all four of the nation's biggest banks are now free to compensate their employees as they see fit and (eventually) start paying meaningful cash dividends to shareholders.

Now that the Big Four banks are out of TARP ( J.P. Morgan (JPM) repaid its $25 billion back in June), we expect to see major pressure on the large regional TARP recipients in the coming quarter.  PNC (PNC) is now TARP's largest investment in the retail banking world. Other major banks with TARP funds include  SunTrust (STI),  Regions Financial (R) (F),  Fifth Third (FITB),  Huntington (HBAN),  KeyCorp (KEY), and  Zions (ZION). Many of these banks are not profitable at the moment and would prefer to see a clear peak in loan losses before looking to return TARP capital, in our opinion. 

Commercial and commercial real estate loans are still deteriorating at a rapid rate, and despite promising early indicators, consumer loan losses continue to climb. None of these smaller banks are subject to the Pay Czar's salary oversight, which eliminates one major reason to exit TARP. Consequently, we believe that although some of the healthier smaller banks will exit the program (possibilities include PNC and SunTrust), others (like Regions Financial) will likely have to wait until their earnings start to recover and shareholders appear willing to accept another round of capital raises.

Valuations by Industry
The rapid rebound in bank stock prices paused in the fourth quarter. Stocks in our covered banking universe declined slightly during the quarter, even as our fair value estimates started to increase. U.S. regional banks continue to be the best spot to hunt for bargains, while REITs and international banks are actually slightly overvalued, according to our assumptions.

 Bank Industry Valuations
   Star Rating Price/Fair
Value*
P/FV Three
Months Prior
Change (%)

Uncertainty Percentile**

Investment Brokerage 3.02 1.01 1.21 -16.5 83.0
International Banks 2.94 1.04 1.18 -11.9 92.0
Money Center Banks 3.12 0.83 1.04 -20.2 89.8
REITs 2.89 1.04 1.07 -2.8 81.8
Specialty Finance 3.31 0.77 0.77 0.0 90.9
U.S. Regional Banks 3.54 0.83 0.85 -2.4 38.6

Data as of 12-14-2009.
*Market-Weighted Harmonic Mean
**Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage.

The biggest valuation changes took place among money center banks, where our aggregate price/fair-value ratio dropped from slightly overvalued to undervalued. This reflects a combination of lower stock prices and a series of sizable fair value increases in U.S. banks, including Wells Fargo and Bank of America.

We raised Wells Fargo's fair value after gaining more clarity on consumer loan losses. BofA's fair value increase followed its TARP repayment, at which point we took a few nightmare scenarios out of our probable-outcomes analysis. During its third quarter earnings call, Wells Fargo went so far as to call a peak for consumer loan losses in mid-2010. Early-stage consumer loan delinquencies point to the beginning of a turn, but it will take several months for these trends to roll all the way down to charge-offs--which we believe will leave most banks with increased provisions in fourth-quarter earnings. We'll know in mid- to late January. 

Our appraisal of regional banks barely moved during the quarter, though this subsector still represents one of the most undervalued areas of our banking universe. The potential for a peak in consumer loan losses will definitely benefit these banks, but the increase in commercial and commercial real estate losses could outweigh these benefits in the short run, depending on the product mix of each bank. 

Although Wells Fargo suggested commercial loans losses could peak toward the end of 2010, we are not as sure. These losses are just now becoming meaningful, and commercial real estate loans, which are usually much larger than residential, could do serious damage--especially to smaller banks. Underwriting and collateral, as well as the condition of local economies, become paramount, making bottom-up analysis essential for choosing which banks will successfully handle rising commercial loan losses.

Our Top Bank Picks
Using our bottom-up approach, we have identified four interesting opportunities in our banking universe that investors might do well to keep an eye on. 

 Top Bank Sector Picks
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty

 

Bank of America $23 Narrow High
City National $64 Narrow Medium
United Bankshares $26 Narrow Medium
Zions Bancorporation $26 Narrow High
Data as of 12-16-2009.

 Bank of America (BAC)
Having repaid its TARP funds and raised nearly $20 billion of fresh equity, Bank of America is set to show off its earnings power later in 2010.  In the near term, bottom-line results will still be plagued by consumer loan losses, gains from investment banking are likely to decline as credit spreads tighten, and charges related with the TARP repayment need to flow through the financial statements in the fourth quarter. A messy quarter, however, might create a buying opportunity for one of the largest consumer banks in the U.S. We believe its massive earnings power will probably encourage a quick rebound once the consumer losses have peaked.

 City National (CYN),  United Bankshares (UBSI), and  Zions (ZION)
The consumer loan loss peak will help our other three bank recommendations, though to a lesser extent as these firms are far more concerned with commercial loan losses. Yet, we single these institutions out for their conservative underwriting standards, which should lead to lower loan losses compared with peers. 

City National and United Bankshares have already shown that their underwriting is much better than peers. While losses are likely to increase in fourth-quarter results, both should continue to outperform. Zions is the most beleaguered of the regionals we recommend, with heavy exposure to construction in several boom and bust states. However, we believe its conservative underwriting standards, which require low loan-to-value ratios, will allow the company to prosper in the long run.

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Jaime Peters does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.