U.S. Banks Industry Outlook (May 2011)

A major recovery in the asset markets, improving balance sheets and declining credit costs promise growth for the U.S. banking sector. Yet, the outlook for the industry remains in question due to several negatives, including asset-quality troubles, the continuation of both residential and commercial real estate loan defaults, weak loan demand, and the impact of tighter regulations and policy changes.

After enduring overwhelming recessionary shocks, the U.S. banking industry is now slowly recovering. 2010 can be certainly characterized as a year of reform. Financial support from the U.S. government ultimately transformed to comparative stability during the year.

The government had taken several steps, including programs offering capital injections and debt guarantees, to stabilize the financial system. Also, the banks are working hard to address problem credit, primarily in residential and commercial real estate. However, the industry is still grappling with weak revenue, ebbing loan demand and low liquidity challenges.

After more than two and half years of initiating the Troubled Asset Relief Program (TARP), a lot has improved with respect to the economic crisis. Also, looking back at the calculation released by the Treasury in March, TARP will finally earn about $23.6 billion by 2013. Considering the effectiveness in easing credit and capital market pressure, restoring confidence in the financial system, and recovering the injected money at a lower-than-expected cost, it can be concluded that the government’s highly criticized bailout program has finally turned out to be a winner.

Out of the total $700 billion bailout money, about $245 billion was handed out to banks in 2008. With repayments by SunTrust Banks, Inc. (STI), KeyCorp (KEY) and Financial Institutions Inc. (FISI) in March, taxpayers have recovered a total of $251 billion from bailed out banks, realizing profit of about $6 billion. This recovery includes dividends and interest income from banks.

However, more than $20 billion is still due from over 550 institutions. Once these institutions reimburse, profits from the bank bailout will increase even more.

With more banks releasing reserves, we expect provision for loan losses to continue declining at least till the end of 2011. Also, the problems with small banks might end up under the wing of bigger institutions.

Clearly, the banking system is not yet out of the woods, as there are several nagging issues that need to be addressed by the government before shifting the strategy to growth. We believe that the U.S. economy will regain its growth momentum once these are resolved.

Macroeconomic Headwinds

There are several macroeconomic factors that may cave in the profitability of the U.S. banks.

Among others, the quantitative easing policy (QE2) of the Federal Reserve is expected to significantly reduce long-term rates, which will keep net interest margins under pressure.

Though the financial reform law signed by President Obama in 2010 empowers the government to tighten regulations for companies that could jeopardize the economy, these may pose threats to profitability for the country’s biggest banks in the near- to mid-term. Many restrictions under the law related to proprietary trading and interchange fees are the most notable among such risks.

Then again, while the implementation of Basel III will boost minimum capital standards, there will be a short-term negative impact on the financials of U.S. banks as they will have to adjust their liquidity management process.

Bank Failures Continue

While the financials of bigger banks have been stabilizing on the back of an economic recovery, many smaller banks are still struggling to survive. Rock-bottom home prices along with still-high loan defaults and unemployment levels continue to trouble such institutions relentlessly.

Many banks continue to shoulder the lingering effects of the financial crisis. It becomes a prerequisite for such banks to absorb bad loans offered during the credit explosion, making them susceptible to some severe problems. As a result, we continue to see bank failures.

Furthermore, government efforts have not succeeded in restoring lending activity at the banks. Lower lending will continue to hurt margins and the overall economy, though the low interest rate environment should be beneficial to banks with a liability-sensitive balance sheet.

Eventually, the strong banks will continue to take advantage of strategic opportunities, with the big fish eating the little ones.

Adding to the banking woes are the lingering economic concerns. While the economy is in a recovery phase, a lot remains to be done. The Treasury continues to hold huge direct investments in institutions like Fannie Mae (FNMA) and Freddie Mac (FMCC).

However, according to an article published by Standard & Poor’s on December 1, 2010, U.S. banks are expected to slowly improve their profitability with the fall of credit costs in 2011.

Additionally, Fitch Ratings retained its stable outlook on the banking industry for 2011. The rating agency expects the financials of banks to improve modestly as macro conditions will take some time to stabilize.

Though it will be a while before we can write the end for this crisis story, banks are expected to perk up in 2011.

OPPORTUNITIES

Regulatory requirement of focusing on banking institutions toward higher-quality capital will help banks absorb big losses. Though this would somewhat limit the profitability of banks, a proper implementation would bring stability to the overall sector and hopefully keep bank failures in check.

Specific banks that we like with a Zacks #1 Rank (short-term Strong Buy rating) include Webster Financial Corp. (WBS), State Bancorp Inc. (STBC), Independent Bank Corp. (INDB), Chemical Financial Corp. (CHFC) and TriCo Bancshares (TCBK).

There are currently a number of stocks in the U.S. banking universe with a Zacks #2 Rank (short-term Buy rating). These include BOK Financial Corp. (BOKF), Access National Corp. (ANCX), Ameris Bancorp (ABCB), Arrow Financial Corporation (AROW), Bancorp Rhode Island Inc. (BARI), Tower Financial Corporation (TOFC), Enterprise Financial Services Corp. (EFSC) and Bridge Capital Holdings (BBNK).

WEAKNESSES

The financial system is going through massive deleveraging, and banks in particular have lowered leverage. The implication for banks is that the profitability metrics (like returns on equity and return on assets) will be lower than in recent years.

Furthermore, the financial crisis has resulted in industry consolidation, which might expedite in the upcoming quarters.

Among the Zacks covered U.S. banks, Bank of America Corporation (BAC) currently retains a Zacks #5 Rank, which translates into a short-term Strong Sell rating. Also, based on the company’s disappointing first quarter results and the Federal Reserve’s objection to its proposed capital deployment in the second half of 2011, we maintain our long-term Underperform recommendation on the stock.

Also, there are currently three more stocks with a Zacks #5 Rank (short-term Strong Sell rating), which are MBT Financial Corp. (MBTF), Princeton National Bancorp Inc. (PNBC) and Washington Banking Co. (WBCO).

By: Kalyan Nandy

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