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Quarter-End Insights

Our Outlook for Bank Stocks

Bank stocks go for a wild and divergent ride.

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Bank stocks have been on a wild ride of late, which is perhaps the understatement of the year. At the beginning of the third quarter, concerns surrounding the viability of  Fannie Mae (FNM) and  Freddie Mac (FRE) and what trouble at those two mortgage behemoths might mean for the housing market had investors running from just about every bank stock we follow. After what appeared to be panic selling and flat-out capitulation going into the lows on July 15, investors began differentiating banks by quality of assets, funding sources, and leverage employed.

Speaking of funding, investment banks and other wholesale-funded institutions came under substantial pressure later in the quarter, even as high-quality regional banks continued an enormous rally from recent lows. The specific concerns surrounding the pure investment bank model centered on high leverage, varying amounts of illiquid assets, and the need to continually roll over short-term funding. After regulators let Lehman Brothers fail, which meant bondholders wouldn't be made whole for a change, creditors backed even further away from financial institutions, precipitating Treasury Secretary Henry Paulson's attempt at a broader bailout. This bold maneuver is geared toward leaving behind the game of whack-a-mole that resulted as creditors and counterparties shied away from one institution after another.

Valuations by Industry
After all of the recent turmoil and divergent trading in the sector, many of the more attractive banks are no longer the bargains they were as recently as July. In fact, some of the highest-quality regional banks like  Valley National (VLY) briefly touched 1-star ratings in the wake of the bailout announcement, a long ride from their recent status as 5-star calls.

Among regional banks, the most troubled institutions like  Washington Mutual (WM) continue to suffer from doubts about asset quality and potential capital-raising. Meanwhile, the large global banks like  Citigroup (C) with substantial investment banking subsidiaries (and related wholesale funding) have also come under question during the recent turmoil, as they were considered the next most likely candidates to fall prey to the game of dominoes.

In general, we expect continued stock volatility because of dramatic swings in the credit markets resulting from systemic deleveraging of balance sheets in the financial sector as well as the broader economy. It is also a bit unsettling when you consider the fact that future fundamentals--in terms of write-downs of illiquid assets and resulting capital levels--will be affected by the bailout bill that is being debated in the halls of Congress and beyond. Assuming that this bill is passed and implemented rather quickly, and that the government is willing to buy these troubled assets at a high enough price to avoid further capital destruction, we would expect the credit markets to become more amenable to financial-services firms in general. As to what the banks do with the capital gained from stuffing Uncle Sam's coffers with illiquid assets, it is unclear how much will be lent back out versus used to deleverage and protect the balance sheet from further declines in real estate prices and a worsening economy.

Bank Stocks for Your Radar
Despite the recent rally among high-quality stocks in our sector, we still see some opportunities, shown in the chart below.

 Stocks to Watch--Banks
Company Star Rating Fair Value Estimate Economic
Moat
Fair Value Uncertainty

 Stewardship

American Express  $65 Wide Medium A
Barclays $49 Wide High N/A
Discover $35 Narrow High N/A
NYSE Euronext $63 Narrow High B
Synovus  $16 Narrow High B

Data as of 09-23-08.

 American Express (AXP) is suffering from worsening credit trends in its loan portfolio, but the market seems to be forgetting just how attractive the firm's interchange business is, as each additional swipe produces tremendous incremental profitability with little associated cost.

 Discover (DFS) also benefits from owning one of the few credit card transaction processing businesses, but on a smaller scale.

 NYSE Euronext (NYX) benefits from a network benefit similar to that of the credit card companies, but its listing business is even more attractive, given recurring revenue and sticky customers.

 Barclays (BCS) has sold off with along with most other European banks, but we think it stands to benefit from the current turmoil, as evidenced by its recent purchase of Lehman's U.S. business on the cheap.

 Synovus (SNV) is a regional bank in the U.S. Southeast with meaningful exposure to troubled homebuilders, but we think it will work through its problems and prosper on the other side of the current mess.

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