Slim Pickings in the Financial Sector

Determined investors might look to a few small banks and, depending on the government bailout, to mortgage-loan holders

As the Obama Administration plans a renewed effort to fix the banking system, bank stocks are on a wild ride. On Jan. 28, rumors of a government program to isolate toxic assets in a "bad bank" sent Citigroup (C) shares up 19%. Over the next two days the gain was lost. Instead of betting that megabanks will recover soon, mutual fund pros are hunting for smaller ones with strong enough balance sheets to survive the credit crunch and recession.

The pool of banks to consider is small, says researcher SNL Financial. Of the 2,756 U.S. banks that SNL tracks that have assets of at least $200 million, only 352 had a return on assets of at least 1.5%—a basic measure of profitability in banking—in 2008, through the third quarter. Limiting the list to banks with minimal losses (nonperforming loans less than 0.5% of total loans) leaves 155 survivors; just 29 have publicly traded shares.

Some pros favor community banks. Anton Schutz, manager of top-performing Burnham Financial Services fund, says those with conservative standards "are alive and well." He says TFS Financial (TFSL) in Cleveland has a strong ratio of capital to assets and the funds to make more loans. And People's United Financial (PBCT) in Bridgeport, Conn., with more than $2 billion of capital above the required regulatory amount, wants to buy rivals on the cheap, he says.

One way to bet on a banking revival is via real estate investment trusts that own mortgage-backed securities (MBS). If a new federal program buys such battered securities from the banks, that would stabilize the MBS market and boost the value of the REIT's portfolios. Schutz bought shares of Redwood Trust (RWT), down 69% over the past year.

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