U.S. Banks Stock Outlook - Aug. 2011

Zacks

Whatever be the impending economic state, U.S. banks -- the lifeblood of the economy -- are actively responding to every legal and regulatory pressure. In fact, this prompt responsiveness has positioned the banks well to encounter upcoming challenges.

Along with improving results in recent quarters, 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, weak revenue growth, steeper costs, continuation of both residential and commercial real estate loan defaults, weak loan demand, and the impact of tighter regulations and policy changes.

Though near-term performance of the banking industry is expected to face several uncertainties, entering the revised capital regime will improve the industry’s long-term stability and security.

Most importantly, federal regulators have said that capital requirements for banks and credit unions would be unaffected by Standard & Poor's downgrade of the U.S. credit rating earlier this month. As a result, there will be no additional burden on them due to the downgrade.

Looking back, after enduring overwhelming recessionary shocks, the U.S. banking industry has gradually started recovering. 2010 can be certainly characterized as a year of reform. Financial support from the U.S. government ultimately transformed to stability during the year.

The government undertook 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 the industry. 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 successful.

Out of the total $700 billion bailout money, about $245 billion was handed out to banks in 2008. With repayments by several banks, taxpayers have recovered a total of $255 billion from bailed out banks, realizing a profit of about $10 billion. This recovery includes dividends and interest income from banks.

However, a lot of money is still due from over 550 institutions. Once these institutions reimburse, profits from the bank bailout will increase even more. The Treasury now estimates bank bailouts to net $20 billion in profit.

With more banks releasing reserves, we expect provision for loan losses to continue declining at least until the end of 2011. Also, the problems of the 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 weigh on the profitability of the U.S. banks. The most important of these factors is the uncertain outlook for the U.S. economy.

Following the release of the weaker-than-expected second-quarter GDP report and sharp revisions to earlier growth numbers, we now know that the U.S. economy entered the second half with a lot less momentum than was earlier thought. These concerns have showed up in the sharp stock market losses in recent days, exacerbated at times by the expansion of the European debt crisis to include thus far immune countries like Italy and France.

The extremely low interest rates across the yield curve is another manifestation of this uncertain macro backdrop. Concerns about European finances and the soft U.S. growth prospects have made treasury instruments the choice safe asset class.

As a result, yields on benchmark treasury bonds have been hovering around record low levels, ignoring the rating downgrade by the S&P. The Fed’s commitment to keep the Fed Funds rate at current levels for another two years is adding to this low interest rate trend, which is keeping net interest margins under pressure for the banking industry.

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.

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 processes. In the long run, though, greater capital cushion for the larger banks will add to their ability to withstand future shocks.

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.

Lingering effects of the financial crisis continue to weigh on many banks. It becomes a prerequisite for such banks to absorb bad loans offered during the credit explosion, making them susceptible to severe problems. The uncertain environment is aggravating the risk of 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. Earlier this month, Standard & Poor's downgraded the credit rating of the U.S. a notch from “AAA to “AA+ for the for first time
since 1917.

Moreover, as the Treasury continues to hold huge direct investments in institutions like Fannie Mae (OTC BB:FNMA.OB - News) and Freddie Mac (OTC BB:FMCC.OB - News), S&P also lowered the ratings of these two government-sponsored enterprises to “AA+ from "AAA.

However, 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 awhile before we can write the end for this crisis story, banks are expected to perk up as the economic picture stabilizes.

OPPORTUNITIES

The 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 Bridge Capital Holdings (NasdaqGS:BBNK - News), Central Valley Community Bancorp (NasdaqCM:CVCY - News), TriCo Bancshares (NasdaqGS:TCBK - News), Heritage Commerce Corp. (NasdaqGS:HTBK - News), Chemical Financial Corp. (NasdaqGS:CHFC - News), German American Bancorp Inc. (NasdaqGS:GABC - News), MidWest One Financial Group, Inc. (NasdaqGS:MOFG - News), Hudson Valley Holding Corp. (NYSE:HVB - News), Webster Financial Corp. (NYSE:WBS - News), First Bancorp (NYSE:FBP - News), Ameris Bancorp (NasdaqGS:ABCB - News), Texas Capital BancShares Inc. (:TCBI) and Encore Bancshares, Inc. (:EBTX).

There are currently a number of stocks in the U.S. banking universe with a Zacks #2 Rank (short-term Buy rating). These include Fifth Third Bancorp (:FITB), KeyCorp (:KEY), U.S. Bancorp (:USB), Cascade Bancorp (:CACB), First Republic Bank (:FRC), CoBiz Financial Inc (:COBZ), Preferred Bank (:PFBC), First Financial Corp. (:THFF), Old Second Bancorp Inc. (:OSBC), Community Bank System Inc. (:CBU), Tompkins Financial Corporation (:TMP), BancorpSouth Inc. (:BXS) and Capital City Bank Group Inc. (:CCBG). 

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.

Also, there are currently seven stocks with a Zacks #5 Rank (short-term Strong Sell rating). These are The Bank of New York Mellon Corporation (:BK), Orrstown Financial Services Inc. (:ORRF), CenterState Banks, Inc. (:CSFL), Eastern Virginia Bankshares Inc. (:EVBS), Tennessee Commerce Bancorp Inc. (:TNCC), Yadkin Valley Financial Corp. (:YAVY) and Southwest Bancorp Inc. (:OKSB).

Zacks Investment Research



More From Zacks.com
View Comments