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By Jeremy Glaser | 05-17-2011 04:21 PM

Credit Quality Slowly Improving at Regional Banks

Regional banks are benefiting from higher credit quality, but concerns about the mortgage market, commercial real estate, and regulation loom.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The Wall Street Journal recently named six Morningstar equity analysts among the Best on the Street, and we are here today with Michael Kon. He was named one of the best banks analysts. We'll talk a little bit about that industry and what his favorite pick is right now.

Michael thanks for joining me today.

Michael Kon: Thank you, Jeremy.

Glaser: So let's talk a little bit about the banking industry in 2011. Certainly it's a sector that's bounced back from the depths of the recession, but how are the regional banks in particular performing right now?

Kon: Well, it's a mixed bag for regional banks. On the plus side, credit quality has started slowly to improve, but there are some concerns out there still. Commercial real estate is still a concern; the mortgage market has its own issues. But overall, credit quality slowly is improving.

On the negative side, regulation is getting tougher and tougher. The regulatory costs are increasing. Banks are now required to hold more capital on their books, and loan demand is very, very weak.

Glaser: Do you think that these regulations are affecting some of the smaller banks more than the larger banks, or is it to early to tell who is going to take the brunt of these actions?

Kon: There are lot of new rules all over the place, and if I look in terms of quantity, most of them are aimed toward the larger institutions, such as the investment banks and the consumer lenders. There are less and less rules for small regional players. But some rules could be meaningful in terms of the impact they will have on their earnings. For example, with the interchange rules, financial reform entitles the Fed to come up with fees on the interchange that banks earn on their credit cards, and those could become substantial numbers for small community banks. If the fees are cut by 90% as the Fed recommended a few months ago, that could be a major hit to some small players.

Glaser: You mentioned that loan demand has been pretty week. Has that been kind of uniform across all different types of loan types? Or have people been more willing to say spend on credit card but are less willing to take out a new mortgage.

Kon: The consumer in general is deleveraging. So we see demand for credit card loans coming down; we see demand for mortgages coming down. There's almost no activity in the real estate market. We see a lot of refinancing going on, but other than that, the demand for new mortgages is really tepid. On the commercial side, we see some activity mostly because banks have to dispose of problem assets, and we see a lot of activity in that area. A lot of investors are shopping for bargains in the commercial real estate space trying to pick good assets from banks that took over an asset because of a default of their clients. But other than that, there is not much demand for commercial and industrial loans. There is not a lot of demand for new construction; the construction market is dead. And the commercial real estate space, except for some activity in the distress properties, I would describe it as a very slow-moving market.

Glaser: Now, looking across your coverage universe, what is your favorite pick right now?

Kon: I still favor Discover. It's been a name I've been recommending to clients for quite a while throughout the recession. The stock has done very well since the lows of 2009, but I still think there is some upside. Discover is a company that came prepared to the credit card crisis. Its balance sheet was in great shape. It had the liquidity needed to survive the financial crisis. It had enough reserves and enough earnings power to absorb the high-loan losses that came with the recession and the high levels of unemployment. Now, as its emerging from the other end of the cycle, when loan losses are dropping, we see earnings going up.

The reason I like Discover the most is because there is a growth potential for this firm. It has invested a lot in its network business. It bought Diners Club International a few years ago from Citi at a very distressed sale, a fire sale by Citi. It bought a debit card network several years ago, and now it's offering a full set of payment products to cardholders and third-party issuers. I think that could generate a lot of volume growth down the road.

Glaser: Michael, congratulations. Thanks for your thoughts today.

Kon: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.

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