The Gloomy Outlook for Regional Bank Stocks

I had the chance to spend an hour yesterday with Erika Penala, bank analyst at Merrill Lynch.

Erika has been following financial stocks for Merrill for a number of years. Her best call - and the most gutsy - was to put "sell" ratings on most the bank stocks that she was following back in 2006.  Bank managements squawked at the time, but her call was spot on.

In other words, she is not afraid to "call 'em as she sees 'em".

Erika was in a good mood yesterday, but the outlook she gave for many of the stocks that she follows was not particularly optimistic.

Banks face two major problems.  The most important is the very low level of interest rates.  With yields so low, it is difficult for banks to earn a decent net interest margin.  The difference between longer maturity yields on assets like mortgages and what the banks have to pay on deposits has become very compressed, and there is little sign that this will change any time soon.

The other problem that nearly every bank faces is tepid loan growth.  Companies and individuals are deleveraging, making it difficult for lenders to grow their loan books.

Erika feels that regional banks are particularly vulnerable at this point.  Regionals have benefited in recent years from the troubles at the money center banks, since they were not saddled with some of the huge legacy issues as their larger brethren.  Now it appears that companies like Bank of America and JP Morgan are gradually coming out from under their problems, so the competition for good quality loans will only increase.

At this point, Erika feels that none of the regional banks she follows warrant investor attention.

That's right:  exactly none.

No, instead she would move into the money center banks, which are trading at historically attractive valuations and have the ability to generate earnings even in a low rate environment.

Her favorite stock is Citigroup (C), which she thinks could move +30% from today's levels.

Citi is trading at 0.65 tangible BV, and has a couple of near term catalysts on the horizon.

C will benefit from new management team that has a banking focus and a track record of getting results.  Earnings should benefit in 2013 from a gradual release of reserves (the loans have not turned out to be as bad as originally feared) and more expense cuts (i.e. layoffs). 

In addition, assuming C “passes” the Fed’s exams in the spring of next year, investors will become heartened that management finally will have turned the corner.  In addition, passing the Fed’s stress tests will allow C management to return more capital to shareholders in the form of dividends and stock buybacks.

I must confess that I have not been a fan of Citigroup for many years.  I have always found the company too difficult to analyze, and management too eager to pay themselves monstrous salaries. 

Still, given Erika's good track record, perhaps I need to take another look.