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S&P: Still positive on regional banks

Despite the current financial markets turmoil, Standard & Poor's Equity Research has a positive 12-month fundamental outlook for the U.S. regional banking industry.

Despite the current financial markets turmoil, Standard & Poor’s Equity Research has a positive 12-month fundamental outlook for the U.S. regional banking industry. S&P’s U.S. Regional Banks Equity Analyst Erik Oja expects that one year from now, credit quality will have improved, loan loss provisions will be markedly lower, lending margins will remain wide, and loan growth should gradually turn positive.

It is certainly true that news headlines are overwhelmingly pessimistic, on fears that a government debt and banking crisis amongst the European Community’s weakest members may pull down the economies of its strongest members, and possibly cross the Atlantic to the United States. However, Oja is looking out to a year from now, and his recommendation is premised on the United States avoiding the feared double-dip recession.

To be sure, financial regulatory reform will bring many changes to the banking industry, and may have an overall effect of slowing banking industry growth and increasing the costs of regulatory compliance.

However, Oja thinks that much of the U.S. regional banking industry may be able to avoid the most restrictive aspects of the upcoming regulatory reform. For instance, possible restrictions on proprietary trading, executive pay, and derivatives may affect only the largest regional banks to any degree, while essentially leaving alone the mid-size and smaller regional banks. These provisions may hit the largest money center banks, and the investment banks the hardest. In addition, the largest U.S. banks generally have thinner capital cushions than do mid-size regional banks, and may be forced to bolster their capital levels by 2011.

The “too big to fail” provisions of the House and Senate bills are aimed at the much larger, money-center banks, with very diverse business models and a high degree of interconnectivity with the U.S. economy. The largest U.S. regional bank covered by S&P Equity Research is PNC Financial Services, with March 31 assets of $265 billion, about one-seventh the size of the each of the three largest U.S. money center banks. Also, PNC emerged from the recent financial crisis relatively unscathed. The effects of the “too big to fail” provisions of the financial reform legislation are hard to estimate, and a risk is that it may hurt U.S. regional banks by protecting a small group of the largest banks.

It is true that U.S. regional banks will likely not escape some aspects of regulatory reform, particularly if a consumer protection agency is created. Such an agency could lead to additional restrictions on debit and credit cards, which have, in recent years, been a lucrative source of income for U.S. regional banks. Previously enacted restrictions on overdrafts have had the effect of reducing fee income at regional banks, though not as badly as originally feared, based on first quarter results reported in April.

Oja thinks the main two reasons to be positive on regional banks, in the upcoming year, are 1) credit quality should keep improving at a significant pace, and 2) loan growth should turn positive by the end of the year. Earnings for 2010 and 2011 should benefit from much lower loan loss provisioning expenses than previously expected. He expects total loan loss provisions to peak in mid-2010 and gradually decline in the second half.

Also, while credit quality of commercial lending, particularly for new real estate developments, is still declining, the rate of this decline is much slower than Oja had expected earlier this year. He thinks this rate will be slow enough so that most banks will not have to raise additional equity capital.

Barring a double-dip recession, loan growth should also pick up by the end of 2010. Loan growth has been negative for most banks, and has declined, on a sequential basis, in each of the past several quarters. Although many categories of loans, such as commercial and residential construction will likely not see any growth in 2010, some growth in 2010 should come from commercial lines of credit, mortgages on existing properties, and from leasing activities.

Summing up, Oja thinks that mid-size regional banks should fare relatively well, and be able to avoid the heaviest brunt of regulatory reform borne by the biggest banks, as well as the regulatory and capital challenges faced by the smaller community banks.
For investors who agree with this thesis, the next question becomes how one goes about putting it into action in one’s portfolio. Answering that question depends in part on gauging an investor’s investment objectives and risk tolerance. For individual stocks, S&P Equity Research has buy (4-STARS) recommendations, as of June 1, 2010, on Fulton Financial, Bank of Hawaii, East-West Bancorp, TCF Financial, Signature Bank, and Boston Private Financial. These banks all have assets of $20 billion or less. Larger regional banks with assets over $50 billion, favored by Oja, include BB&T, PNC Financial Services, FifthThird, M&T Bank, Huntington Bankshares, and Comerica. S&P’s STARS recommendations are subject to change at any time, as are its ETF and mutual fund recommendations.

Stock table

SYMBOL	NAME	STARS	PRICE($)	MARKET VALUE TOTAL($MIL)	RELATIVE STRENGTH	52-WEEK HIGH	52-WEEK LOW
BOH	BANK OF HAWAII CORP.	4	47.97	2307.45	67	54.1	33.65
BBT	BB&T CORP.	4	30.32	20929.16	44	35.72	19.83
BPFH	BOSTON PRIVATE FINANCIAL HOLDINGS, INC.	4	7.14	506.82	59	8.96	4.01
CMA	COMERICA INC.	4	37.9	6717.86	54	45.84	19.68
EWBC	EAST WEST BANCORP, INC.	4	16.73	2515.11	51	20.55	5.75
FITB	FIFTH THIRD BANCORP	4	12.85	10332.6	51	15.95	6.31
FULT	FULTON FINANCIAL CORP.	4	10	1757.22	61	11.75	4.72
HBAN	HUNTINGTON BANCSHARES INC.	4	6.11	4414.1	87	7.4	3.26
MTB	M&T BANK CORP.	4	78.88	9418.94	49	91.47	43.5
PNC	PNC FINANCIAL SERVICES GROUP, INC.	4	62.34	33009.63	77	70.45	33.06
SBNY	SIGNATURE BANK	4	38.13	1543.34	66	43.12	25.73
TCB	TCF FINANCIAL CORP.	4	15.97	2294.51	63	19.17	11.36
^{STARS represent S&P Equity Research’s evaluation of the 12-month potential for stocks, with 5-STARS (strong buy) assigned where total return is expected to outperform the total return of a relevant benchmark over a wide margin over the coming 12 months, and 4-STARS (buy) assigned where total return is expected to outperform the total return of a relevant benchmark over the coming 12 months.} ^{For important regulatory disclosures, please go to www.standardandpoors.com, and click on “Regulatory Affairs.”}

In contrast, investors looking for exposure to US regional banks, but who also want to benefit from holding a diversified security, may consider exchange-traded funds or mutual funds. S&P rankings on ETFs and mutual funds incorporate a rigorous analysis of each portfolio’s underlying holdings to assess valuation and risk, and are not based simply on past performance.
S&P has an overweight rating on three ETFs that have one or more of the above-listed stocks within their top-ten holdings.

ETF table

FUND NAME / TICKER	S&P RANKING	YTD*	1-YEAR*	3-YEAR*	5-YEAR*	CURRENT PRICE	EXPENSE RATIO
iShares Dow Jones US Regional Banks Index Fund / IAT	OW	14.9	34.5	-19.9	NA	24	0.48
iShares S&P Global Financial Sector Index Fund / IXG	MW	-9	12	-21.5	-6.2	41	0.48
^{Data through 5/28/10. *Total returns include reinvested dividends and capital gains, all annualized; calculations do not reflect the effect of sales charges. MW-Marketweight. OW-Overweight. NA-Not available. Source: S&P ETF Reports.}

As for mutual funds, S&P has a four or five-star ranking on four equity mutual funds, all of which have a top-ten holding in at least one of the above recommended stocks.

Fund table

FUND NAME / TICKER	S&P RANKING	YTD*	1-YEAR*	3-YEAR*	5-YEAR*	CURRENT PRICE	EXPENSE RATIO
FBR Large Cap Financial Fund; Investor / FBRFX	5	3.1	27.3	-6	0.3	13	1.86
FBR Small Cap Financial Fund; Investor / FBRSX	5	14.6	37.2	1.5	2.4	20	1.58
Fidelity Select Banking Portfolio / FSRBX	3	15.9	40.1	-15.8	-6.6	18	0.93
John Hancock Regional Bank Fund; A / FRBAX	4	9.4	31	-10.8	-3.2	15	1.52
Data through 5/28/10. *Total returns include reinvested dividends and capital gains, all annualized; calculations do not reflect the effect of sales charges. S&P Mutual Fund Rankings reflect an analytical mixture of past performance metrics with an assessment of a fund’s holdings and cost factors. A S&P five-star fund is ranked in the top 10% of its category. a four-star fund is in the next 20%. A three-star fund is in the middle 40%. Source: S&P Mutual Fund Reports.

Note: The fund rankings in this article — from five star (best) to one star (worst) — are quantitatively derived from performance, holdings, risk, and expense analysis. The stock rankings, or STARS — using a scale of 5-STARS (strong buy) to 1-STARS (strong sell) — are based on S&P equity analysts’ qualitative and fundamentally-driven outlook for the stock over the next 12 months; NR stands for not ranked.
To get access to Standard & Poor’s Equity Research go to www.getmarketscope.com, or call 1-877-219-1247, or send an email to [email protected].

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