After enduring extraordinary shocks in 2008, U.S. banks entered an exceptional state of turmoil in 2009. Starting as a credit issue in the subprime segment of the mortgage market, the sticky situation spread to almost the entire financial services industry and all corners of the globe. In other words, the financial crisis ultimately morphed into a massive economic crisis, which has had major ramifications across the whole world.

Although the banking industry is dealing with liquidity and confidence challenges, it now has financial support from the U.S. government. The government has taken several steps, including programs offering capital injections and debt guarantees, to stabilize the financial system.

We believe that the worst of the credit crisis is now probably behind us. After almost a year of initiating the $700 billion Troubled Asset Relief Program (TARP), a lot has improved with respect to the economic crisis. But the banking system is not yet out of the woods, as there are persistent problems that need to be addressed by the government before shifting the strategy to growth. We believe that the U.S. economy will regain its growth momentum once these issues are resolved.

While the bigger banks benefited greatly from the various programs launched by the government, many smaller banks are still in a very weak financial state and the Federal Deposit Insurance Corporation’s (FDIC) list of problem banks continues to grow. In the second quarter of 2009, the number of banks on the FDIC’s list of problem institutions grew to 416 from 305 in the first quarter. This is the highest number since the savings and loan crisis in 1994.

Despite the government’s heavy efforts, we continue to see bank failures. Increasing loan losses on commercial real estate are expected to cause more bank failures in the next few years. The FDIC anticipates the bank failures to cost about $70 billion over the next five years.

Furthermore, government efforts have not succeeded in restoring the lending activity at the banks. Lower lending will continue to hurt margins, though the low interest rate environment should be beneficial to the banks with a liability-sensitive balance sheet.

Out of the $240 billion given to banks, $70 billion has come back as the healthiest banks have started repaying TARP funds. The Treasury Secretary estimates that banks will repay another $50 billion over the next 12 to 18 months. Also, taxpayers have received decent returns on many of its financial-sector investments. Repayments under the TARP have generated a 17% annualized return from stock-warrant repurchases and $12 billion in dividend payments from dozens of banks.

Many of the financial institutions that have already repaid the bailout money include JPMorgan Chase (JPM), American Express (AXP), Goldman Sachs (GS), Morgan Stanley (MS), Capital One (COF), BB&T (BBT) and US Bancorp (USB). Also, banks like Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C) are expected to exit TARP over the next 12 to 18 months.

However, the situation is about to be reversed as regulators are considering asking healthy banks to bail out the government soon, in order to replenish the FDIC’s coffers. The increasing number of bank failures has caused a rapid decline in the FDIC’s funds as it has been appointed receiver for the failed banks.

Also, following the U.S. Treasury’s announcement requiring the world’s banks to maintain stronger capital and liquidity standards by the end of next year to prevent a re-run of the global financial crisis, 15 large banks that control the majority of derivative trading worldwide have committed themselves to maintaining greater transparency in the $600 trillion market that needs stricter oversight in the interest of the global financial system.

However, there are lingering concerns related to the banking industry as well as the economy. Continued asset-quality troubles are expected to force many banks to record substantial additional provisions for the remainder of 2009 and all of 2010. This will be a drag on the profitability of many banks for extended periods and will further add stress to their capital levels.

For the last few quarters, the banks have mainly suffered due to the losses in mortgages and Commercial Real Estate (residential construction loans). Housing prices have continued to decline, and given the sharp increase in the level of unemployment we anticipate continued losses in these portfolios. Furthermore, deterioration in other Commercial Real Estate loans is now rising at a rapid pace and the downturn in this class is also likely to emerge as a major challenge.

Given the negative macro backdrop, we expect losses to continue to increase in the other asset classes as well, especially in consumer-related loans.

While the state of the economy is showing signs of recovery, a lot remains to be done. The Treasury continues to have huge direct investments in institutions like American International Group (AIG), Fannie Mae (FNM) and Freddie Mac (FRE).

We expect loan losses on commercial real estate portfolio to remain high for banks that hold large amounts of high-risk loans. Also, as a result of a rise in charge-offs, the levels of reserve coverage have fallen over the past quarters and the banks will have to make higher provisions in the coming quarters, affecting their profitability. We think that the financial crisis is far from over, and we will have to wait awhile to write the end line of the crisis story.

OPPORTUNITIES

The Treasury’s requirement of focusing banking institutions towards higher-quality capital will help banks absorb big losses. Though this would somewhat limit the profitability of banks, a proper implementation would bring stability to the overall sector and hopefully address bank failures.

We favor Commerce Bancshares Inc. (CBSH) in this space since this company is one of the few names that did not report losses even during the current financial crisis. We believe that Commerce is one of the best capitalized banks in the industry, and will generate positive earnings throughout the credit cycle. While the bank had a decent growth in deposits in the most recent quarter, trends in its credit metrics were in the negative direction.

WEAKNESSES

The financial system is going through massive de-leveraging. Banks in particular have lowered leverage. The implication for banks is that the profitability metrics (like returns on equity and return on assets) will be lower than in recent years.

Furthermore, the current crisis has dramatically accelerated the consolidation trend in the industry. As a result, failure of a large financial institution will be a major concern in the upcoming quarters as weaker entities are absorbed by larger ones.

We think banks with high exposure to housing and Commercial Real Estate loans, like Wilmington Trust Corporation (WL), KeyCorp (KEY) and Zions Bancorp (ZION) will remain under pressure.
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