Buy the banks—the regional banks, that is.
Weeks before the sweeping rescue plan that Treasury Secretary Henry Paulson announced on Sept. 19, regional banks PNC Financial Services Group (PNC), BB&T (BBT), and SunTrust Banks (STI) already emerged as the financial stocks of opportunity, as they had become way undervalued.
They became even more undervalued on Sept. 22, when regional bank stocks declined on concern among some investors that they could be hurt by the Treasury's proposal to shield from losses investors in money-market funds, which compete with the banks' deposits. "I think the risk is overblown," says Jeffrey Kleintop, chief market strategist at LPL Financial. The idea behind the stocks' decline, says Kleintop, is that because many of the banks have their mortgage securities designated as "held for investment," they haven't taken writedowns, and that if they then sell them they have to write them down. But most assets are held near their fair value at the regional banks, says Kleintop.
What is more important is the conversion of Goldman Sachs (GS) and Morgan Stanley (MS) into bank holding companies, he says. It means that if Goldman and Morgan want to develop a large deposit base in order to diversify and lower their cost of funds, they would have to do so by buying regional banks. "This means the biggest regional banks may now attract potential buyout bidders, which might help lift their valuations," says Kleintop.
With the fast-moving events in the federal government's efforts to save the beleaguered financial system, the attractiveness of the regionals' shares has definitely grown. Shares of these banks had been in a free fall until the Treasury and the Federal Reserve Board announced the bailout of Fannie Mae and Freddie Mac on July 15. Before then, things were beyond bleak: The S&P 500 Regional Bank Index had plunged to 45 by that day, from 140 in mid-February of 2007. The index has nearly doubled since then, to 80.31 on Sept. 18.Look Who's a Haven Now
Some of the regionals hold a lot of the preferred shares in Fannie and Freddie as cash equivalents to support the loans they provide. The preferreds could have wiped out the regionals had the two giant providers of liquidity to the mortgage market collapsed. PNC, for example, had to take a charge of $80 million.
"Once the deal to bail out Fannie and Freddie came together on July 15, the scope of the problem became clear, and it became obvious that the regional banks would benefit from the continuing operations of Fannie and Freddie, even though the sizable dividend of about 7% on the preferreds has been suspended," says Kleintop. The regional banks now have become a " haven of safety," he adds. The banks' shares are already 60% above their 52-week lows and continuing to move upward. "They are now attractive buys and represent good value," says Kleintop. The Regional Bank Index still has a long way to go to regain its old highs, he notes.
Shares of PNC, whose primary markets include Delaware, Florida, Massachusetts, New Jersey, Ohio, and Pennsylvania, have rallied sharply, hitting a new high of 81.21 a share on Sept. 19, up from 49 on July 15. The stock dropped to 75.60 on Sept. 22. But PNC could still post double-digit gains that outpace the overall stock market, says Kleintop. Second-quarter revenues jumped 19% from a year ago, while net interest income, which accounts for some 48% of revenues, climbed 32%.