Wednesday, January 13, 2010

Credit Challenges Continue in Banks 12 January 2010

4Q09 Earnings Preview – Credit Challenges Continue

Maintaining cautious posture on regional banks — We remain cautious on the sector and selective in our recommendations ahead of 4Q09 earnings. We would remain buyers of BB&T (BBT.N; US$27.34; 1H) and SunTrust (STI.N; US$23.27; 1H) and remain sellers of Zions shares (ZION.O; US$16.51; 3S). We believe both BBT and STI offer meaningful upside based on the profitability of their franchises post cycle, versus the current valuation of their stock and believe the market has not fully factored in dilution risk in ZION.

A few positive trends in an otherwise tough quarter — We expect NIM expansion, a moderation of net NPL formation given relatively stable early stage delinquency trends and restructuring activity, expense control and somewhat lower loan loss provisions to drive narrower operating losses for banks that posted sizable hits to their capital bases in 3Q09. Narrower losses should result in slowing rates of capital depletion for most of our banks this quarter. Combined with capital raises completed in 3Q09 we expect regulatory capital ratios to remain relatively stable in 4Q09. We continue to view BBT as the best positioned large-cap regional bank in terms of capital flexibility post cycle and continue to believe that the market is incorrect in its assessment of capital risk (and valuation of the stock) at STI longer term.

Too soon to call for a turning point — Negatives will not be hard to find in 4Q09 results. Shrinking balance sheets are likely to suppress revenue growth, net charge-offs are likely to edge higher, troubled debt restructuring activity should escalate further, and capital risk should increase for those with sizable DTAs in their capital base (e.g. ZION). Further, still vulnerable economic conditions in many regions and increasing delinquencies in CRE loans (both on bank balance sheets and securitized) increase the risk of elevated credit losses. Banks with significantly above average CRE + Construction exposures include SNV and ZION. We would note that STI has substantially below average exposure to CRE. While BBT has above average exposure to CRE + Construction, it also has strong profitability and excess capital.

Declining Loan Balances

Loan portfolios should continue to shrink in our universe (Figure 3) reflecting run-off in higher-risk loan categories (e.g. residential construction), riskaversion by banks, lack of loan demand by clients facing uncertain economic conditions and banks’ efforts to manage regulatory capital ratios. Data provided by the U.S. Treasury point to flat origination activity by TARP recipients in October compared to September. Several banks in our coverage have commented on soft loan demand by their business clients and guided for smaller balance sheets in 4Q09. Among banks in our coverage, we expect average loan balances to decline the most at MI and SNV, two banks with high CRE/construction exposures that have been active in reducing their risk exposures. It is worth noting that we forecast loan growth at TCB and NYB which is reflective of the unique business models of those two companies and recent acquisition activity.

[source: Citibank]

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