Bank Stocks: The Smartest Plays Now

Despite the prospect of continued woes if commercial loan defaults spike, investors may see attractive opportunities in the months ahead

By David Bogoslaw

There's been a huge sigh of relief breathed by investors in U.S. banks since the Treasury-ordered stress tests that concluded in early May. In the weeks since, banks have raised an aggregate $16 billion in equity, putting many of them in a much better position to deal with a looming problem: losses on loans still to come, particularly from commercial real estate loans.

Defaults on commercial property loans are widely viewed as the next bullet for the economy to dodge on its precarious route to recovery. Regional banks tend to be the ones with the highest exposure to these loans, which many borrowers will find difficult, if not impossible, to refinance upon maturity given rising vacancy rates and negative equity based on towering loan-to-value ratios and subsequent declines in property values.

Even after the runup in stock prices for the sector since March, valuations for many banks remain enticing. The question is how to distinguish between a great deal on a name that's likely to rebound and overpaying for a stock that's in the dumps because that's where it belongs.

"All regional banks are pretty much underprovisioned [for loan losses because] losses are coming too fast," says Paul Miller Jr., an analyst at Friedman Billings Ramsey (FBR) in Arlington, Va. Banks are supposed to have adequate provisions on their balance sheets to cover two years' worth of losses on commercial loans, he says.

Climbing Defaults

Default rates on commercial loans are expected to continue to climb through 2012 as property appraisals catch up with the sharp drop in property values around the country and as loans mature. Even properties on which borrowers made 30% down payments are underwater where property values are down 33% to 40%, and in many cases loans were made with much lower down payments, says Richard Green, director and Lusk Chair in Real Estate at the Lusk Center for Real Estate at the University of Southern California. That will become a bigger problem as those loans come due and borrowers try to refinance.

"On one hand, regional banks don't want to foreclose and have the property on their balance sheet," he says. "On the other hand, everyone's capital-constrained, so they don't want these loans they were planning to be rid of to hang around on their balance sheet because then they can't make new loans." He estimates that $350 billion in commercial loans will mature over the next two to three years.

Whether banks are willing to refinance loans that mature or opt to write down the value of those loans, their capital positions are likely to be too tight to allow for much new lending, which suggests a protracted and less dynamic recovery for the U.S. economy.

The banks whose loan portfolios are clearly heavily weighted toward geographic regions such as Georgia and Florida, where real estate values have fallen especially hard, should be fairly easy for investors to put aside. That includes SunTrust Banks (STI) and Synovus Financial (SNV), while Marshall & Ilsley (MI) made lots of loans to housing developers in California during the bubble.

It All Depends

How big a problem these losses turn out to be will depend on the health of the economy. If it is in the process of bottoming and begins to expand in the second half of 2009, then commercial lending will continue to decline a little over the next two quarters, while banks should have enough capital to cover any losses on those loans, says Erik Oja, an analyst who covers the banking sector at Standard & Poor's Equity Research. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP)).

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