Mortgages: Smaller Banks Smell Blood

Plain-vanilla banks known for careful lending could benefit from the problems of larger, more aggressive rivals like Countrywide

Everyone says there's a credit crisis, with defaults on risky mortgages causing banks and mortgage brokers to tighten up their lending.

So why is Mark Tryniski, chief executive of Community Bank System (CBU), a bank in upstate New York and northeast Pennsylvania with assets of $4.5 billion, actually boosting his mortgage lending? And why are many other small and midsize banks doing the same?

For years, smaller, local banks were left in the dust by huge, innovative, and fast-growing competitors. Now amid all the pain and sometimes panic in credit markets, the plain-vanilla banks see big opportunities. Investors looking for a bright spot amid the credit-market woes might turn to these banks, who may see their careful ways finally pay off.

Steering Clear of Subprime

Tryniski's bank has boosted its mortgage originations by 15% from a year ago. Community Bank System executives are developing a marketing campaign to further promote the bank's real estate lending business.

Until recently, lenders like Countrywide Financial (CFC), IndyMac Bancorp (IMB), American Home Mortgage (AHMIQ), and Accredited Home Lenders (LEND), were tough rivals and stock market favorites. They originated huge numbers of mortgages and then resold them to investors on credit markets. Small banks couldn't originate mortgages as efficiently and weren't willing to take risks on nontraditional borrowers.

While the big brokers and banks often lent to home buyers with lousy credit histories, the more conservative, traditional banks wouldn't touch subprime borrowers with a 10-foot pole.

Now, partly as a result of that risky lending, many big lenders are faltering. They're cutting back lending and a handful, including American Home, ended up in bankruptcy as many investors refuse to buy up their mortgage debt.

Squeezed Out of the Mortgage Market

The differing fates for traditional banks and their edgier rivals goes to the heart of the current credit crisis. When brokers were simply reselling mortgages on a secondary credit market, they had little incentive to think deeply about a borrower's personal situation or ability to repay. "It only mattered what statistical category" the loan fell into, Michael Englund, chief economist at Action Economics, wrote recently. Selling innovative, mortgage-backed securities to outside investors "reduced the value of actual information about risk."

When traditional banks lent money, they were more careful. They often keep a mortgage on their books, so they know they'll be on the hook if a borrower defaults.

"These companies are generally lending to people that they know," says Mark Fitzgibbon, director of research at Sandler O'Neill & Partners.

In recent years, as competition from the likes of Countrywide heated up, many small banks pulled back from mortgage lending, says Keefe, Bruyette & Woods (KBW) banking analyst Jared Shaw. With everyone offering low interest rates, mortgages were more like a commodity, and banks couldn't make enough profit on them.

Riding Out the Storm

Now with the secondary market frozen and many mortgage lenders falling by the wayside, interest rates are changing and mortgages are becoming more profitable. Customers are also seeing local banks as a more reliable lender. "Borrowers are coming to us because if we make a loan commitment, we can close the deal," Tryniski says.

Nearly the entire financial industry has been hit by worries about a growing credit crunch. Bill Sammon, director of capital markets at Howe, Barnes, Hoefer & Arnett, an investment banking firm focused on community banks, points out that banks listed on the Nasdaq exchange are down about 13% so far this year.

But not every bank and financial institution has been hit equally. Banks with more than $10 billion in assets are down 13.6%, and banks with $1 billion to $5 billion in assets are down more than 25%. However, banks with less than $500 million in assets were down only 8.3% by mid-August.

There are thousands of publicly traded small banks out there, and potential investors must be careful. Some did make risky loans, and some are being hurt by falling real estate markets in California, Florida, and elsewhere. Another thing investors must be aware of, according to Sammon: Many of the smaller bank stocks trade relatively infrequently. That makes it easy for just a little extra buying or selling to push a stock around.

Positive Trends for Traditional Banks

In this environment, analysts like banks with a conservative lending history.

"The biggest risk is always credit quality," says James Schutz, director of research in the financial institutions group of Sterne Agee & Leach Group "Nothing will hurt a bank's performance faster than a whole lot of bad loans."

A strong balance sheet also helps. Banks with lots of depositors and capital can afford to take advantage of the current environment by making more loans.

Fitzgibbon of Sandler O'Neill recommends banks like Astoria Financial (AF) and Hudson City Bancorp (HCBK). Keefe's Shaw also likes Hudson City, and says his top pick is People's United Financial (PBCT). There are also mutual funds and electronically traded funds that focus on banking stocks, though they might contain a mixed bag of big and small banks with different credit records. (KBW may do business with People's and Hudson City in the next three months.)

Analysts and experts see other positive signs for traditional banks: An interest rate cut by the Federal Reserve, which many expect is coming soon, would help boost bank profits. And a wave of mergers and acquisitions in the banking industry continues to lift stock prices among smaller banks that are buyout targets.

The biggest question for banks may the broader economic environment. If the economy slows, real estate prices plunge or millions of Americans lose their jobs, it will get tougher for even the most reliable borrowers to pay back their loans.

A Fundamental Shift

Action Economics' Englund wrote this week that he believes we may be seeing a fundamental shift in the banking industry. This might be the end of a decades-long trend of bypassing banks in favor of more and more sophisticated financial instruments traded on credit markets. "It will take time for us to transition back to borrowing from banks and not mortgage brokers," he says in an interview.

Ultimately, both investors and home buyers may prefer to deal with their local bank rather than a huge national lender.

Fitzgibbon says some smaller banks are actually hoping that Countrywide, the largest mortgage lender in the U.S., will go bankrupt or at least cut back their lending sharply. "A lot of banks are rooting for that because [Countrywide has] been a tough competitor for so many years." With Goliath faltering, the Davids of the mortgage-lending world appear to have their slingshots at the ready.

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