Misplaced Fears for Regional Banks?
The good news is the regional banks followed by Standard & Poor's are well-insulated from the subprime lending market crisis. The question is: How exposed is this group to "Alt-A" mortgages, which cover the large middle ground between subprime and prime loans?
Investors are worried about regional bank exposure to Alt-A mortgages, given M&T Bank's (MTB; ranked 3 STARS, hold) profit warning on Mar. 30. The bank indicated the market for the Alt-A loans that it packages and securitizes has cooled off, leading to lower prices and lower mark-to-market prices for the loans that aren't sold. M&T Bank says it's contractually liable to buy back nonperforming Alt-A mortgages. The bank also warned that deposit costs would be higher than expected, leading to further net interest margin compression.
Alt-A loans are issued to customers with generally clean credit histories, but borrowers aren't subject to the level of income verification and documentation they would be with a prime loan. Alt-A customers are often independently employed, such as contractors, or they work in cash businesses. Banks stress Alt-A is a product type (low documentation and lower loan-to-value), whereas subprime is a customer type (low credit scores). In the first half of 2006, 16% of mortgage originations by dollar volume were Alt-A, vs. 62% for prime, 19% for subprime, and 3% for other.
As for subprime, the regional banks we at S&P cover generally have very limited, if any, exposure to the subprime lending market. Regional banks aren't among the top 20 subprime lenders, according to the National Mortgage News list of fourth-quarter originations. Subprime lenders are often smaller, specialized companies or are smaller units of large multinational banks like HSBC (HBC, ranked 3 STARS, hold), Wells Fargo (WFC; ranked 3 STARS, hold), and Citigroup (C; ranked 5 STARS, strong buy). Furthermore, the regional banks that did have subprime businesses sold off those units.
M&T Bank is the bellwether of the U.S. regional banks industry, since it reports first and because of its size—$43 billion in loans and $57 billion in assets as of December 31, 2006. However, we don't think investors should view M&T's issues as widespread.
For example, in January, M&T Bank announced a large increase in their quarterly loan loss provisions. However, as the earnings season progressed, only some banks followed suit, and some didn't have to augment their provisions at all. Though it's important to pay attention to M&T Bank's news, we also note regional banks have very different lending portfolios and securitization programs.
The Main Issue
SunTrust (STI; ranked 4 STARS, buy) has $1.8 billion in Alt-A loans out of a loan portfolio of $121.5 billion. PNC Financial (PNC; ranked 4 STARS, buy) doesn't disclose the level of its Alt-A loans, but has said it's "immaterial," and PNC doesn't securitize customer loans, as M&T Bank does. KeyCorp (KEY; ranked 4 STARS, buy) also doesn't disclose the amount of its Alt-A lending, but we believe it's insignificant.
Regions Financial (RF; ranked 4 STARS, buy) has about $2 billion to $4 billion of Alt-A loans held for investment out of its $94.5 billion loan portfolio. Regions completed the sale of its Equifirst mortgage origination business on Apr. 2 to Barclays (BCS; ranked 4 STARS, buy). Equifirst originated prime, Alt-A, and subprime loans.
We have a different view and think the main issue in M&T Bank's earnings shortfall is related to deposit costs. While Alt-A problems are serious, we think they're second in importance. For some time, M&T Bank has struggled with deposit gathering, more so than its peers. For the earnings season, which begins on Apr. 16, we think investors in regional banks should focus on the larger issues of deposit costs, net interest margins, and credit quality of the entire loan portfolio.