Emerging Trends In Regional Banks

Date Published: 8/25/09 Updated 8/27/09

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Emerging Trends in Regional Banks Abstract: Last week, Colonial Bancgroup was seized by the FDIC. With assets of over $25 billion, it was the 5th largest bank ever to fail. In total we have seen 81 banks fail in 2009 and more than 150 more banks may be in significant trouble. We examine the regional banking industry to find the next candidates for failure and examine how the FDIC can handle the expected increase in failures.

As the market roars on, the number of bank failures is also increasing. This past week has seen the 5 largest bank failure in our history. In total, at the time of writing, 81 banks have failed in 2009, a number not seen since 1992. Recently, an article is out from Bloomberg stating that 150 other banks may be in trouble based on the ratio of non-performing loans (NPLs) to total loans. The FDIC's latest quarterly report says that more than 400 institutions are in trouble! th

The wild card in the regional banking industry is the FDIC, which is now out of money. The situation at the FDIC may start a new trend in regional bank deals and closings. Because of the tight capital strains on the FDIC, it can not burden may more multi-billion dollar hits from bank failures such as Colonial, which cost the FDIC about 3 billion dollars. It is reported that the FDIC was watching Colonial Bank as far back as 6 months ago for signs that it was in trouble. Waiting until last week cost the FDIC significantly more money then if it pulled the plug on Colonial earlier. It is our speculation that as more banks fail, and the FDIC's funds get closer to 0, we will see an accelerated pace of bank closures by the FDIC to limit the damage that failed banks do to the FDIC's remaining insurance fund. To better show the current situation, we look at several graphs released by the FDIC in their latest report:

So the FDIC has no money, but more and more banks are in trouble which puts more assets at risk. However, fewer and fewer banks are profitable, so the FDIC raising insurance rates to cover their shortfall may do more harm than good as those banks are already in the red. Something has to give.

Which Banks are on the watch list? Well, thats confidential. But Bloomberg names a few in their article... “The biggest banks with nonperforming loans of at least 5 percent include Wisconsin’s Marshall & Ilsley Corp. and Georgia’s Synovus Financial Corp., according to Bloomberg data. Among those exceeding 10 percent, the biggest in the 50 U.S. states was Michigan’s Flagstar Bancorp.” Generally, Federal regulators consider anything over 5 percent to be signs of considerable weakness. Although, it is far from a guaranty that the bank will be shut down. The article from Bloomberg goes on to list several other interesting statistics. Nationally, of the 7.7 trillion dollars worth of bank loans outstanding in the US, 2.6 percent are nonperforming. This number is not an all time high though, in 1991 this number hit 3.27 percent as the Savings and Loans crisis was ongoing. If our current situation is worse and more widespread than the S&L crisis in the early 90's, we have a long ways to go. And that may mean trouble for a large number of banks. To start we listened to a couple larger bank's recent conference calls to see what insight they could offer in our search for vulnerable banks. Zions Bancorp (NASDAQ:ZION) Zion is a regional bank that operates in the western US. They have net assets of 58 billion dollars, and have bought assets from four other failed banks this year. Zion's conference call is a wake up call to anyone who thinks our economy is in better shape than a year ago. Some highlights of the call: To quote the call: “Significant increase in problem loans relative to where we were 6 to 9 months ago...” An analyst asked “What markets give you the most concern?” To which Zion replied “all of them...its still a pretty crummy economy” And they added that they are seeing deterioration in all markets. They highlighted several specific areas of trouble. The entire Northwest, The energy services in Texas which have lead to problems in housing in Texas and “non real estate” (meaning construction loans in particular based on other comments during the call). Zion saw its NPL's (non performing loans) jump 17% to 1.9 billion dollars. Obviously not a good sign. Zion's total NPA (nonperforming assets) stands at 4.68%. Another troubling quote from Zion, “further property declines lead to dollar-to-dollar write offs in Arizona and Nevada”. This comes as data released today shows home prices dropped 19% in California last month. Arizona, Nevada and California have typically seen similar action in housing prices. It is safe to say, that Zion is seeing strong decline in property values in Arizona and Nevada still which may lead to further write downs. According to the call, Las Vegas and Southern California are the weakest markets they are in, while Utah and Colorado represent their strongest markets. Zion's management said the most critical aspect of business for them is the core net interest margin, which was at 4.09% for the second quarter. That is up .18% from the first quarter of this year, but down from a year ago. Net interest margin represents the profits they receive from interest on loans

and other investments minus the interest they pay on deposits. This is a key statistic to watch for in their next quarter's earnings announcement. The fundamentals on Zion are not pretty, and it is obvious the bank is struggling through the deteriorating market conditions they are experiencing. However, because of the size of Zion bank, it is an unlikely candidate for a takeover by the FDIC any time soon. Zion should give investors a chance to see what next quarter brings before making a significant investment decision. We are recommending a sell rating on Zion as we see signs of deteriorating market conditions. Our short term sentiment will change if Zion's share price breaks above $20 as that may indicate the rally the market has experienced may have more legs. Next we look at Synovus Bank (NYSE:SNV), which was highlighted in Bloomberg's article for having a high percentage of nonperforming loans. Synovus is out of Georgia but also operates branches out of other states including Florida, Tennesse, South Carolina and Alabama. Synovus has total assets of 34.3 billion dollars of which 6.24% are nonperforming, which represents a very small decrease from last quarter. Synovus was asked about performance of their loans based on region by one analyst. Synovus is seeing a positive trend in the Atlanta housing market, but they said that there are “potentially more issues out of Floria.” Florida was one of the early states hit by the crisis, and apparently is not through it yet. As mentioned in previous articles by Hylland Market Research, the real estate market may have a ways to fall, which puts a lot of banks in danger. The surprising part of Synovus's call was their expectation to return to profitability by first quarter 2010. However this seems to be on some overly optimistic assumptions. Synovus is betting that commercial real estate will not follow residential real estate and will in fact recover soon . Many are bearish on commercial real estate, and rightfully so. Look at recent earnings reports from commercial real estate companies, and you will see that the deterioration is not over. If commercial real estate does continue down, keep an eye on Synovus. We believe that Synovus may be setting up investors for a disappointment come 2010 and for that reason recommend a sell rating on Synovus. Our sentiment will change if commercial real estate begins to recover faster we forecast it to or if Synovus's share price breaks above $5.25. Synovus's share price has struggled considerably, and is barely above its lows put in during March representing the bearish sentiment from investors which is shared by us. Next we look at another company featured by Bloomberg, Marshall & Ilsley Corp. (NYSE: MI) MI is the largest bank we will highlight, with just under 60 billion dollars in total assets. MI operates primarily in Wisconsin but is also present in Florida and Arizona. MI is seeing the largest deterioration in construction and development loans and is working hard to reduce their loans in that category. Construction and development loans represent 43% of MI's nonperforming loans. Next is Commercial Real Estate (CRE) loans, which represents 22% of its NPL's. In total 4% of CRE loans are currently nonperforming. From information gathered by Zion's and Synovus's conference calls, we know that where MI has lent out the majority of its loans are in areas that others see as very risky and rapidly deteriorating. MI has taken aggressive actions to reduce its exposure to these areas, however some doubt if it is enough. Recently an article was published by Dow Jones News questioning if MI is adequately

capitalized. The author, Michael Rapoport writes: “the fair value of Marshall & Ilsley's loans is 10%, or $4.6 billion, lower than carrying value. Recognizing that would cut deeply into M&I's $5.3 billion of Tier 1 capital and leave the bank with a Tier 1 ratio of about 1.40%, far below levels that would satisfy regulators.” This brings to light an issue that we have not touched on yet, and that is the new accounting rules and “mark to market”. Banks do not have to show the current value of assets on their balance sheet, but can instead show what they consider the “fair value”. This rule was recently changed and was the cause for the sudden turn around in bank's earnings. Look at Wells Fargo Bank for example. It followed up its worst performing quarter ever with its best performing quarter ever. Apparently though, someone believes it, as the stock has skyrocketed. But these troubled assets are still sitting within many banks balance sheets and it may only be a matter of time before these loans may be too much for banks to bear, such as what happened with Colonial Bank. There are several other regional banks that we would like to bring to investor's attention. Sterling Financial Corp. (NASDAQ: STSA) is a bank that has 12 billion dollars in assets and that we believe may be in trouble and may not survive through 2009. Sterling Financial operates out of Washington state, a state that has seen one of the largest recent jumps in foreclosure rates compared to the other states. 6.35% of Sterling's assets are nonperforming and we forecast conditions to worsen through 2009. Our sentiment on Sterling's stock will change if it is able to rally significantly above $3.50 a share. Lastly, we want to highlight Western Alliance Corporation (NYSE: WAL). They operate banks out of Arizona, California and Nevada. WAL has nonperforming assets of around 3%, lower than the other banks highlighted, but several other parts of the balance sheet may hint of trouble. WAL's non interest expenses have jumped 24%, indicating trouble controlling expenses. WAL also has seen a large increase in past due loans, which may be a leading indicator of increased future nonperforming loans. How do investors play a bearish outlook on regional banks? An investor betting on individual banks has several options. Simple buying of shares (if bullish) or shorting of shares (if bearish) will certainly work. However, we prefer to play individual banks with options instead. Many regional banks have seen a significant run up in share prices and implied volatility has dropped to 52 week lows, which makes options, specifically put options, on certain regional banks relatively cheap. The difficulty with options is choosing the right month for expiration of the option. For banks discussed within this article we believe the January 2010 expiration represent enough time for significant moves in the stock price, while not costing an investor too much. For investors looking for a safer approach, there is a regional bank ETF, symbol KRE. Should the regional banking industry struggle and experience an increase in failures, KRE will certainly fall in price. An investor shorting, or buying puts on KRE is also more diversified compared to speculative bets placed on individual banks. Keep in mind the increased risks with options and the speculations made in this article. We are currently in a market where government intervention can come at any moment. That said, we believe that many regional banks are 'too small to be saved' (as opposed to 'too big to fail') and will ultimately be taken in by other banks or the FDIC. The published article is property of Hylland Market Research and can not be reproduced in any way without permission by Hylland Market Research. Hylland Market Research is not responsible for loss of capital due to your investments. Investing involves substantial risks.