Banking industry is in distress

The slumping housing market, the subsequent credit crunch and repeated write-downs of underperforming assets have battered the share prices of publicly traded banks over the past year.

Many publicly traded banks are trading between half and two-third their values from one year ago: Marshall & Ilsley Corp. (parent company of M&I Bank) recently traded near $15.50 per share, down from more than $35 per share in November; Associated Banc-Corp has been trading at $19.80 per share, down from more than $33 per share within the last year; and US Bancorp (parent company of US Bank) has been trading at $28.09, down from a 52-week high of $35.25.

Many other banks are in similar situations, and banking analysts say it’s all because of overexposure to residential home construction.

“In my opinion, the banking industry is facing the most challenging operating environment I have seen in a long time,” said Zuheir Sofia, a managing member covering banks with L&S Partners, a financial services hedge fund based in Cleveland, Ohio.

Bank analyst Gerard Cassidy of RBC Capital Markets recently caused some jaws to drop on Wall Street when he told MarketWatch.com that he expects at least 150 banks across the United States to fail over the next two to three years.

If the current economic malaise deteriorates into a full-blown recession on the scale of the 1980s and early 1990s, the number of American bank failures will grow much higher, possibly to as many as 300, Cassidy predicts.

Despite low stock prices, mergers and acquisitions within the banking world are largely on hold now. And M&A within the banking world doesn’t show any signs of picking up later this year.

“Historically, there is a lot more M&A activity (in banking) when stock prices are high rather than low,” said Rick Lane, president and founding partner of Broadview Advisors LLC, a Milwaukee-based investment advisor firm. Lane also serves as the firm’s research analyst in the financial, industrial and business services sectors.

“No one will want to sell their bank now because they won’t get a good price,” he said.

Sofia agreed, and said that many banks still have high levels of their lending portfolios tied up with residential housing, which will further stall M&A activity.

“That kind of balance sheet exposure looks nothing like what we’re used to,” said John Callen, senior client advisor with MBO Cleary Advisors Inc., a Milwaukee-based individual and institutional investment services firm. “There is more apprehension about the (acquisition) target’s viability or attractiveness. That alone will slow the process when capital is in short supply and profits are damaged.”

Many real estate loans have been securitized, bought and sold many times, making it difficult to determine how much bad debt a bank might have, Sofia said, further compounding a difficult banking M&A landscape.

“Everyone else is looking at your portfolio and they don’t know what’s in there,” he said. “Now it looks like doom and gloom.”

Potential buyers will be equally, if not more, cautious.

“Can you imagine how scary it would be to buy a bank now?” Lane said. “Could you do enough due diligence? I think bank management will be very cautious unless it’s a troubled bank (that is being acquired) with the help of the FDIC.”

Michael Sadoff, investment manager with Sadoff Investment Management LLC, agreed.

“Some of the weaker players may run out of room, and that’s the only way to give return to shareholders,” he said. “A lot of the middle market players are too heavily leveraged in the real estate market and if they want to give any return they may have to look for (a merger or being acquired) and they may not have much of a choice.”

There will be a few M&A deals within banking during the current tough credit conditions, Lane said, but those deals will likely be related to banks that are underperforming.

“The only consolidation you will get is the bad kind, when the FDIC or another regulator will go to a financial institution and tell them that they’d better find a partner,” he said. “Or it could be worse, if a financial institution goes into bankruptcy. I think there will be some smaller banks that will get into trouble and will have to be acquired, that went way overboard with residential construction.”

Today’s poor credit conditions that are tied to the housing market are a “pig in the python,” Lane said, that may take up to the next 18 months or longer to work itself out. He believes that bank stocks will begin returning to normal ranges by mid 2010, at which point M&A activity will resume.

“The credit is playing out so badly this time that it will take the rest of 2008 and all of 2009 for the bad credit cycle to pass through the system,” Lane said. “Stock prices typically look out six months. I anticipate a return to a normal credit cycle in 2010, so banks might start acting better in the second half of 2009.”

Callen and Sofia agreed.

“Any consolidation in earnest is not on the near-term horizon,” Callen said. “We’re looking for something that’s beyond this year, maybe next year.”

Sofia believes the credit landscape will improve in the second half of 2009. Once it does improve, consolidation in the banking industry will quickly begin picking up steam, he said.

“People must really feel that the charge-offs are behind them and they are getting a better picture of what they’re buying,” Sofia said.

When M&A activity does pick up again for U.S. banks, international buyers from countries like Canada, England and Spain will want to purchase Midwestern banks, Sofia said, as well as banks with strong Midwest brands such as Wells Fargo, US Bank, JPMorgan Chase and M&I Bank.

“In the Midwest in 2007 there was active consolidation and acquisition by larger banks and even mid-sized regional banks,” Sofia said. “However, we really haven’t seen consolidation of the larger regional banks amongst themselves or by someone else from the outside.”

Once the credit markets have settled down, large national banks looking to enter or strengthen their position in Wisconsin will likely do so through acquisition, Callen said.

“I think that the chance to get locations, branches and exposures to certain lending markets, that will make (Wisconsin banks) very attractive as a target,” he said. “There’s good motivation, but I don’t see a clear path at this point. We’ll have to wait for the macro environment to improve and for someone to lift the pressure from the smaller markets.”

Most of Sadoff’s clients do not own bank stocks. In fact, when the firm lands a new client, the Sadoffs advise them to sell off any financial stocks. However, he has started examining financial stocks in recent months because of their low prices.

“We’re starting to look at some of the bigger ones, but they’re not ready yet,” he said. “I’ve been looking at them recently out of curiosity – there are a lot of real estate issues that they have.”

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