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Banks' Subprime Hits
Weigh on Big and Small,
But Not All Rightfully So

By VALERIE BAUERLEIN

Hardly a day goes by without one of the nation's big banks announcing more bad news tied to subprime mortgages. Investors, worried that the next blowup will hit them square in the portfolio, have driven down bank stocks 28% this year.

The selloff is justified for the likes of Citigroup Inc., Washington Mutual Inc. and Bank of America Corp., but other generally smaller names have been lumped in with the battered big boys. That has created opportunities for investors who are buying high-quality banks that have little or no subprime-mortgage exposure, are trading near book value and may see their businesses improve next year.

Many of these banks are still takeover candidates as the long trend of bank consolidation continues,

Investor favorites run from U.S. Bancorp, the Minneapolis bank with a $55 billion stock-market value, to tiny Community Bancorp of Las Vegas, with a market value of about $185 million.

"We're caught up in the overall hysteria," complains Edward M. Jamison, chairman and chief executive of Community Bancorp, where net income soared 62% in the first nine months of 2007 from a year earlier, helped by two acquisitions. "We have no first-mortgage business, no subprime loans," Mr. Jamison says. "Even though you speak it, the market doesn't hear it."

U.S. Bancorp, the nation's sixth-largest bank by market value, has the highest rate of return on assets, a gauge of efficiency, among its peer group, according to an analysis by SNL Financial of Charlottesville, Va. U.S. Bancorp also has a relatively small 28% of its loan portfolio in real estate.

But U.S. Bancorp shares are down 11% this year, making them look cheap to bank analyst Lori B. Appelbaum of Goldman Sachs. Ms. Appelbaum recommends U.S. Bancorp, describing the company in a Friday research report as "very defensive," as it has shielded itself through careful loan decisions and large reserves.

Kenneth J. Brusda, president of North Star Asset Management Inc., with $1 billion in assets under management, has been steadily adding small bank shares to the Menasha, Wis., firm's portfolio.

"I call it the bank double-play. The valuations are reasonable and you have the possibility of takeouts," he says. "These banks have been beaten up more than they should have."

One of his favorites: First State Bancorp of Albuquerque, N.M., the largest independent bank in New Mexico. A 51% stock-price decline so far this year has pushed the shares below book value, yet loan quality has held up well and the bank is expanding in Colorado. On Friday, First State rose two cents, or 0.2%, to $12.24.

Community's percentage of loans that are nonperforming is less than half that of a peer group. But with Las Vegas known for some of the worst excesses of the housing bubble, the bank's shares are down 40% in the past year. On Friday, they rose 3.5%, or 60 cents, to $17.97 in Nasdaq trading.

One problem facing such banks is their small following on Wall Street, giving them few defenders when investors began turning against the industry. "When Wall Street evaluates them, they have to depend on less-objective measures, like a gut feeling that it's located in a troubled region, or that it has more real-estate exposure than they would like," said Michael Andrews, an analyst with SNL.

Fans of off-the-beaten-track banks say they were far less susceptible to the horrible bets their bigger brethren made on securities tied to subprime loans. Sticking close to home likely helped some of these regional players avoid pitfalls, as long as they didn't get too caught up in real-estate euphoria. Some of these banks were hurt during the boom because more aggressive lenders took away business from them.

Now, not only will they get that lending business back, but less competition also means it will be more profitable.

According to SNL, there are a baker's dozen of small or medium-sized U.S. banks that trade below book value, yet have less than half of their loans in real estate and are outperforming their peers in return on assets. Many of these banks were trading at a premium until the third quarter and aren't haunted by subprime woes.

"Being below book value doesn't make any sense," says Rex Schuette, chief financial officer of United Community Banks Inc., the Blairsville, Ga., parent of 27 community banks in Georgia, North Carolina and Tennessee. With a stock-market value of $819 million, the company has doubled its earnings in the past five years, but the share price has fallen near a five-year low. On Friday, its shares rose 17 cents, or 1%, to $16.99 on Nasdaq.

That said, these cheap banks aren't without potential troubles. Jonathan D. Holtaway, managing director of Danielson Capital Inc., a bank-consulting firm in Vienna, Va., said that while Community Bancorp in Las Vegas is cheap and isn't exposed to mortgages, it does have "massive" exposure to retail-shopping centers. "Can they weather the storm, and after the storm, can they grow?" Mr. Holtaway asks.

Mr. Jamison said his bank has seen continued strong occupancy in retail centers, but acknowledges it will take "consistent performance" to win back wary investors.

Brett Rabatin, a bank analyst at FTN Midwest Securities Corp., says investors who do their homework and are patient will be rewarded when the banking industry starts to rebound. He has been agonizing over a "buy" rating he placed on Sterling Financial Corp. of Spokane, Wash., three months ago. Since then, the stock is down 30%. Sterling rose 71 cents, or 4%, on Friday to $18.60.

Mr. Rabatin is sticking by his call, saying Sterling made solid loans, has clearly divulged its real-estate exposure and its CEO is nearing retirement age, increasing the likelihood of a takeover. "We're getting to a point where if you can hold a stock for two years, these things look awfully attractive," Mr. Rabatin says.

Many smaller banks have long traded at higher valuations in anticipation of a takeover. That premium has disappeared for many because investors feel like the big banks have too many problems to be out shopping. But the pace of deals has continued. There have been 229 bank mergers or takeovers so far this year, down from 247 a year ago, according to SNL.

Mr. Brusda, North Star's president, expects deal activity to accelerate, especially as non-U.S. banks capitalize on the dollar's weakness.