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Financial tsunami didn't hit Midwest banks as hard as coastal ones

This article first appeared in the St. Louis Beacon: October 13, 2008 - In a deteriorating economy, there's good news and bad news for investors in St. Louis bank stocks.

The bad news is that most of these stocks have declined for the 12 months that ended Oct. 10. The good news is that they have done better -- or, rather, less worse -- than the Standard & Poor's 500-stock index (down 42 percent) and the S&P Banking Index of larger banks (down 59 percent).

For investors, important news will come out during the next few weeks as most banks issue financial reports for the July-September quarter. Investors will learn not only about the banks' fundamental strengths and weaknesses but also about predictions for the near -- and perhaps disquieting -- future.

"St. Louis will probably fare better than the coastal markets," says Christopher McGratty, a banking analyst for the firm of Keefe, Bruyette & Woods.

"Many Midwest cities didn't enjoy the housing boom like coastal cities," he adds. That also means their banks shouldn't experience the mortgage-related busts that has hit lenders with heavy exposure to housing in California and Florida, among other markets.

St. Louis probably won't be hit as hard as other regions because "our market income is not based on residential or commercial construction," says Jack Strauss, professor of economics at Saint Louis University's John Cook School of Business.

He says 0.5 percent of the St. Louis area's employment has been tied to construction versus 4 percent nationwide, based on average data over seven years. In California, it's 6 percent and in Nevada it's 13 percent.

"We didn't have significant patterns of overbuilding," says Strauss, who also directs the university's Simon Center for regional economic forecasting. "Most of the area's income is based on health, education and business and professional services, so we're more stable."

ASSESSING IMPACT

However, stability doesn't confer immunity. Investors examining banks' financial reports in the next few weeks should pay close attention to the impact of tightening credit.

Stifel Financial continues to defy stock market gravity as Wall Street investment banking firms have sought buyouts, bailouts and bankruptcy protection.

For the 12 months ended Oct. 10, Stifel's stock broke even, on a split-adjusted basis, while the broad market index -- the S&P-500 stock index -- plummeted by 42 percent.

Match Stifel's performance against any New York investment bank -- at least the ones that still exist independently -- and there's no contest. Goldman Sachs was down 62 percent and Morgan Stanley was down 85 percent. Lehman Brothers is down and out. Bear Stearns has been acquired and Merrill Lynch is being acquired.

Stifel's favorable performance extends to comparisons with giant banking companies whose brokerage units compete with the Stifel, Nicolaus brokerage.

Citigroup was down 68 percent and Bank of America was down 60 percent. St. Louis investors don't have to be reminded of Wachovia; but just in case you're new in town, Wachovia was down nearly 90 percent. Even Wachovia's rescuer, Wells Fargo, was off 23 percent.

Stifel has maintained its equilibrium in part because it hasn't engaged in the adventurous, risky and downright dumb investments that have plagued bigger investment banking firms, brokerages and banks.

"Our business model, which emphasizes client service, does not rely on the leverage which has plagued many other financial institutions," says Ronald J. Kruszewski, chairman and CEO, in a recent letter to customers.

Based on June 30 data, Kruszewski pointed out that Stifel had $1 in capital for each $3 in assets. The average for the large New York banks was $1 in capital for every $30 in assets. Such leverage is the "fundamental cause" for the stock market turmoil, he says in the Sept. 17 letter. "Absolute size is not an indication of financial strength," he adds.

"Stifel is well on its way to expanding from a Midwest/Mid-Atlantic focused regional broker into a more national presence," says a recent research report from Keefe, Bruyette and Woods, one of only two investment banking firms that track Stifel. "More opportunities remain."

Analyst Joel Jeffrey, whose firm has had a recent investment banking relationship with Stifel, gives the company a market perform rating. He has lowered fourth-quarter expectations to 58 cents a share from 66 cents, but he is staying with his 51 cents forecast for the June-September quarter. Stifel usually announces third-quarter results in early November.

Jeffrey, who doesn't own shares, says the projected fourth-quarter dip reflects higher near-term expenses as it conducts an "aggressive growth strategy," fueled by a recent stock offering that raised more than $67 million, excluding transaction fees. The money will be used to hire more investment bankers, financial advisors and others, Jeffrey says. By mid-2009, he predicts pre-tax profit margins will grow again.

"The winners will likely be a relatively small group of banks with strong capital ratios and only moderate credit problems," says an Oct. 2 report by Stifel Financial on trends in Midwest banks. A low percentage of non-performing assets is one key to success.

"We would be somewhat concerned if some of our banks show loan growth this quarter," says Stifel. "While each bank will have its own specific story, the economic environment isn't supportive for loan growth." A substantial jump in loans might make investors nervous about the quality of loans.

Stifel doesn't offer much encouragement to investors interested in Midwest bank stocks. "It is very hard to be optimistic about loan growth or credit quality improvements during the next several quarters," the firm says. "We do not see the pieces for a near-term earnings rebound."

To avoid the collateral damage from Wall Street's woes and from big banks' bungling, St. Louis area banks must have policies that protect them against sharp jolts to the economy.

"In general, small cap banks and savings and loan institutions are less diversified" than large banks, says McGratty of Keefe, Bruyette and Woods. "Many have hung their hats on commercial real estate and construction lending."

In general, McGratty advises clients to reduce their ownership of small- to mid-cap bank stocks; but he adds that these institutions can be conservative.

McGratty says two Missouri banks that he follows, Pulaski Financial and UMB Financial, have maintained conservative strategies and diverse portfolios to help guard against the financial extremes of a poor housing market.

Other analysts say Commerce Bancshares and Enterprise Financial Services appear reasonably well positioned.

Still, for investors, stock market results for most St. Louis banks have been worse than putting their money under a mattress. Looking at publicly traded banks with a St. Louis-area headquarters and Kansas City-based banks with a strong St. Louis presence, the results for the past 12 months ended Oct. 10 were:

  • Commerce Bancshares' stock lost 9 percent on a split-adjusted basis
  • First Clover Leaf Financial lost 20 percent
  • Centrue Financial fell 29 percent
  • Enterprise Financial declined 37 percent
  • Pulaski Financial lost 40 percent
  • UMB Financial gained 5 percent

LOOKING AHEAD

Although UMB's stock performed better than the rest, McGratty has an underperform rating. "It's a valuation call," he says, noting that the stock had risen higher than he believes is justified by the bank's financial foundation.

"I'm not overly concerned about credit," says McGratty, who doesn't own shares and whose firm has had a recent non-investment banking relationship with UMB. "This is a very conservative bank."

McGratty has a market perform rating on Pulaski, which has "done good things in the last two years," such as broadening its financial portfolio and producing "good growth." But McGratty says he's concerned -- as he is for many banks that he covers -- that rising credit costs will eat into profits.

He doesn't own shares.

David Konrad, who works with McGratty, praises Commerce Bancshares for its "strong capital level," a diversified loan portfolio and a "long-standing credit culture."

In a late August report, he gave Commerce a market perform rating. Konrad, who doesn't own shares, kept the rating in an Oct. 2 report.

Commerce received a hold rating from Stifel, Nicolaus in August, which said the bank enjoys "strong credit quality and capital adequacy" performance, enabling it to better absorb the shock of a bear market in bank stocks. Analyst Ben Crabtree, who doesn't own shares, reiterated his rating in early October.

Last month, Crabtree cut his rating on Enterprise Financial to hold from buy because the stock's price had outpaced what he believes is the company's fundamental value.

"We are fans of the bank's business model, its franchise and its management team," he wrote in a Sept. 19 research report. Despite being "relatively optimistic" about long-term growth, Crabtree is worried that Enterprise Financial, "like virtually all Midwest banks, is faced with the probability of a slower-growth economy and higher credit costs." Crabtree, who doesn't own shares, maintained his hold rating in an early October report.

PREDICTING TRENDS

Crabtree's latest report says it's still too early to assess the impact on Midwest banks of the recently enacted federal bailout/rescue law and other changes in federal banking policy.

"We're not sure that the (bailout) will provide a lot of help" to the Midwest banks that he follows, says the report, which was issued one day before President George W. Bush signed the bill into law. This is a "welcome turn of events, but we don't expect it to turn the economy around."

Temporarily expanding the protection of deposits by the Federal Deposit Insurance Corp. "does have some positive implications for the stability and perhaps even growth of the deposits," his report says.

However, this benefit will lead to higher insurance premiums paid by the banks, Stifel adds. Individual account protection is expanded from $100,000 to $250,000 through the end of next year.

"The $250,000 cap is both a concrete and psychological demonstration that depositors won't lose their money," adds McGratty, of Keefe, Bruyette and Woods.

Although the new law will help big troubled banks, the Stifel report says it may not apply to some of the more conservative Midwest banks that it follows.

"The largest problem loan category for many of our covered banks has been loans to real estate developers, and it is not clear that such loans will be covered under the asset purchase program," the Stifel report says. "In sum, we do not expect a major boost" from the law.

Robert W. Steyer is freelance business reporter living in New York. 

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