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Quarter-End Insights

Our Outlook for Bank Stocks

As consumer loan and mortgage defaults show signs of improvement, regulatory reform and M&A take center stage.

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  • With mortgage and consumer loan defaults appearing to bottom, commercial real estate and construction loans remain the Achilles' heel of many banks
     
  • Weak demand for loans will impede organic growth opportunities, likely turning management teams' eyes toward the M&A market even before regulators finish purging the system of troubled banks
     
  • After passing the health-care bill, legislators are finally putting banking industry reform on the front burner

What a difference a year can make. Twelve months ago, the U.S. economy was in terrible shape, credit quality of bank loans was falling off a cliff, and the fear of mass failures in the sector was at its peak. Not surprisingly, most investors treated banks as insolvent entities, and stayed far away. Valuations in the sector collapsed to levels unseen for decades.

Fast forward to today. The mood in the sector has markedly improved from last year and so did stock prices. Insolvency fears subsided, capital markets opened up, and failures of large financial institutions are off the table. Most importantly, after a long and painful climb up, recent data suggest that new defaults on mortgages and consumer loans are finally declining. While commercial real estate remains a serious headache for many banks, the noticeable improvement in mortgages and consumer loans is likely a harbinger for a turn in the credit cycle. This means that banks with sizable consumer loan books might soon benefit from lower credit costs, which would bode well for earnings.

Technically, the recession ended last year, but for many companies in the sector, the game plan remained defense. This might change in the second quarter as management teams, encouraged by positive economic news, shift focus from survival and retrenchment to growth and profitability. But weak demand for loans will hamper attempts to grow organically, forcing managers to scout for acquisitions. The best deals remain the ones that are sponsored by the FDIC after a bank fails. However, most of the failed banks aren't large enough to make a difference for a large national or regional player. Hence, the next M&A wave might take off even before the regulators finish closing all the troubled banks.

With the health-care bill passed, legislators can finally shift their focus to the banking sector. In the upcoming months, we might witness a showdown on issues such as the consumer protection agency and the Volcker Rule. The list of possible outcomes is long, and the sky is the limit as to how far the new regulatory rules could go. No doubt, a complete overhaul of bank regulation might change the competitive dynamics within the sector and derail some business models. The stakes are high, and the fight in Washington is expected to be tough and long.

Industry-Level Insights
Bank stocks resumed their rally in the first quarter. The specialty finance industry and money center banks remain the least expensive in our coverage universe. REITs are the most overvalued group, but valuations aren't extremely excessive. Looking forward, any improvement in the credit quality of loans, especially commercial real estate, should bode well for bank stocks, provided that the economic recovery remains on track. 

Our Top Bank Picks
As stocks rallied, all of the low-hanging fruit in our coverage universe was picked by quick bargain-hunters. Nevertheless, some firms continue to trade substantially below our fair value estimates as the market remains skeptical about their long-term prospects.

We highlight five names that trade above our Consider Buying price, but still significantly below our fair value estimates:

 Top Bank Sector Picks
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty

Price/Fair Value

Bank of America  $23.00 Narrow High 0.74
J.P. Morgan Chase $58.00 Narrow High 0.74
Discover Financial  $27.00 Narrow High 0.57
optionXpress Holdings $21.00 None Medium 0.66
Wilmington Trust  $25.00 Narrow High 0.67
Data as of 03-25-10.

 Bank of America (BAC)
Bank of America's attempts to expand during this crisis have not turned out as well as J.P. Morgan's. The company paid way too much for both Merrill Lynch and Countrywide. However, with TARP repaid and consumer loan losses likely nearing a peak, the future is bright for B of A. It still has one of the largest deposit franchises in the nation and is a low-cost operator in the commoditized retail banking business. The company's bottom line should receive several major boosts as losses start to peak and it no longer has to provision more than it is charging off. With most of the bonus-related Merrill Lynch problems in the rearview mirror, management can finally turn its full attention to the bank.

 J.P. Morgan Chase (JPM)
Despite large loan and securities write-downs and a ton of bad publicity, J.P. Morgan has strengthened its franchise throughout this downturn. Acquiring Bear Stearns and Washington Mutual, J.P. Morgan was able to beef up its retail and investment banks for bargain-basement prices. The company will face some challenges ahead--such as the summer implementation of new overdraft rules that are likely to bite into noninterest income and reduced revenues from the already suffering card business due to the Card Act. However, these challenges should be more than offset by improving results from its consumer loan book. With one of the strongest balance sheets in the market, J.P. Morgan is also likely to be one of the first major banks to raise its dividend.

 Discover Financial  (DFS)
Last year at the peak of the credit crisis, the market doubted Discover could withstand the severe economic headwinds and sent the stock to single-digit territory. Discover has proved the market wrong by posting lower credit costs than peers and maintaining a very liquid balance sheet. The stock rallied since then, but it remains attractive because we believe the market completely ignores the huge potential in Discover's card network.

 optionXpress Holdings (OXPS)
optionsXpress' earnings have a fair chance of outperforming peers' in the near term due to its client and revenue mix. The company's earnings are more levered to trading revenues, which may hold up better than stock-focused peers' as lower volatility decreases the activity of stock trading but may increase the trading of optionsXpress' customers due to lower option volatility premiums. We also see long-term material earnings growth from the company if trades per account approach its historical average.

 Wilmington Trust (WL)
The market is concerned about Wilmington's credit costs going forward. While we acknowledge that Wilmington did a poor job in managing credit risk, the bank's long-term earnings power remains strong mainly due to its dominant position in Delaware and the trust business, which generates a healthy stream of fee income. Credit quality is likely to overshadow results for the near term, but the in long run, Wilmington's prospects remain positive.  

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Michael Kon has a position in the following securities mentioned above: BAC. Find out about Morningstar’s editorial policies.