Our Outlook for Bank Stocks

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Following the stress tests and capital-raising efforts of the second quarter, the banks were flush with new equity and hope in the third quarter--but they were also still awash in a sea of credit losses. Second-quarter earnings calls were filled with suggestions that the consumer credit cycle was nearing its peak. Monthly credit card losses showed some improvement but also showed that any recovery was going to be a bumpy ride.

We believe that the worst of the consumer credit cycle may be approaching. Credit losses could start to stabilize, which will allow banks to stop over-provisioning for consumer credit. However, even as consumer credit starts to stabilize, we expect to see an increase in commercial credit losses. These loans are much larger than consumer loans, and the timing of losses is much more difficult to predict, creating a lumpy loss curve, especially in smaller regional banks. Consequently, we expect to start to see a divergence between the banks. A few regional banks will likely get slammed with large losses due to just a few loans, while others will dodge that bullet and show some stabilization in the third quarter. We expect the hopeful tone will continue to be heard throughout the industry, but a realization that 2010 results are likely to still be poor will finally set in.

Valuations by Industry
After a quick rebound from March lows over the past two quarters, our overall bank stock universe is trading at fair value. Valuations in the industries show a modest increase in price to fair values, with no industry looking particularly cheap. Regional banks are among the cheapest, trading at 0.86 of our fair value, and it is in this fertile hunting ground that a few bargains can be found.

Bank Industry Valuations
	Star Rating	Price/Fair Value*	P/FV Three Months Prior	Change (%)	Uncertainty Percentile**
Investment Brokerage	2.97	1.21	1.15	5.2	61.7
International Banks	2.74	1.18	0.98	20.4	81.9
Money Center Banks	2.91	1.04	0.93	11.8	72.3
REITs	2.96	1.05	0.89	18.0	64.9
Specialty Finance	3.35	0.77	0.68	13.2	27.7
U.S. Regional Banks	3.49	0.86	0.78	10.3	18.1
Data as of 09-14-09. *Market-Weighted Harmonic Mean **Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage.

As the idea of the consumer credit cycle started to spread through the market like wildfire, and the fears about undercapitalized banks abated, stocks continued to rise. This is the case for the largest U.S. and international banks. We believe the market is starting to finally look at the long-term picture for these banks and trying to decide what they might be able to earn in the long run.

The top four U.S. money center banks will look quite a bit different than when the recession began:  Bank of America (BAC),  J.P. Morgan (JPM), and  Wells Fargo (WFC) have grown by leaps and bounds, while  Citigroup (C) continues to need to shrink. We think Wells and J.P. Morgan are very well-run banks and would love to own them for the long run after getting in at a good price. Our uncertainty level for many banks has come down over the course of the quarter, but bargains are hard to find in the top banks.

Brokerages and exchanges are continuing to trade above our fair value estimates as equity issuance during the second and third quarters generated some record fee revenues for some companies. Volatile credit markets allowed companies with capital to rake in the trading gains. As the markets settle down, credit spreads should tighten and additional regulation might limit the amount of risk some investment banks can take, which could reduce long-term trading gains.

Top Bank Picks
We are still finding some opportunities in underappreciated smaller regional banks.  City National ,  East West Bancorp (EWBC),  M&T Bank (MTB), and  Valley National (VLY) stuck to their knitting leading up to the recession and credit crunch. Consequently, they have fared much better than peers and are in a position to take advantage of the disruptions in their local markets.

Top Bank Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/ Fair Value
City National		$64.00	Narrow	Medium	0.59
East West Bancorp		$19.00	Narrow	High	0.44
M&T Bank		$77.00	Narrow	Medium	0.79
Valley National		$17.00	Narrow	Medium	0.71
Data as of 09-28-09.

City National's and East West's California footprint should not scare off investors. These two banks have specialized as conservative commercial lenders. They do not offer the cheapest financing on the street, but they offer a level of expertise and service that customers rely on. With much of the California market in upheaval, these two banks are poised for highly profitable growth even as they stick to their tighter credit standards.

M&T Bank and Valley National dish up a similar story for the East Coast. Valley National's conservatism has proved very profitable in its home state of New Jersey. This bank would actually show paying customers the door before the credit crisis started in order to improve the quality of its loan portfolio. M&T Bank has made its business operating in low-growth areas like Buffalo, N.Y., using tight underwriting standards to preserve profitability. A focus on credit and a healthy balance sheet have allowed M&T and Valley to be two of the very few banks to maintain their pre-crisis dividend payments to date.

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