The wave of bank failures washing over the U.S. is creating opportunities for regional lenders that are strong enough to pick up the debris, with help from the Federal Deposit Insurance Corp.
U.S. Bancorp (USB, news, msgs), BB&T (BBT, news, msgs) and Zions Bancorporation (ZION, news, msgs) have already benefited from buying failed banks in so-called FDIC-assisted deals where the regulator promises to cover a lot of the future losses on the assets being assumed.
Other banks that could do similar deals include Columbia Banking System (COLB, news, msgs), Hancock (HBHC, news, msgs) and People's United Financial (PBCT, news, msgs), according to Keefe, Bruyette & Woods.
More than 100 banks have been seized already this year. "That number could reach 500 or more in future," said Fred Cannon, an analyst at KBW.
KBW reckons a select group of regional banks with sufficient capital, credit quality and management talent will be able to expand, either by rolling up failed institutions or acquiring market share in other ways.
"If you can pick the winners in the regional bank space, there are real opportunities," Cannon added.
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"We're not sure which banks will get these FDIC deals, but we're pretty sure some of them will," Cannon said. "So a basket of these names is a great place to be."
Profitable strategy
Banks are failing at the fastest rate in more than a decade as last year's financial crisis and surging unemployment have left the industry nursing heavy loan losses. More than 1,000 banks may fail during the next three to five years, RBC Capital Markets estimated in February.Buying failed banks can be more profitable than acquiring healthy institutions.
When the FDIC tries to sell a collapsed bank, the regulator tells potential bidders what it thinks the threshold for future losses will be. It then offers to share those losses with the winning bidder.
The FDIC usually agrees to take 80% of losses up to its forecast threshold and then 95% of any losses above that. This means bidding banks have good ideas what their maximum losses would be when they make offers.
The price tags for failed institutions are also often negative -- meaning banks get paid to take troubled companies off the FDIC's hands.
Banks will often pay a slight premium for the deposits of failed institutions, but they will make bigger negative bids for the assets. So far this year, most purchases of failed banks have carried negative price tags, according to FBR Capital Markets.
"With FDIC assistance, you basically get paid to do the deal -- cash in hand," said Paul Miller, an analyst at FBR. "The FDIC takes most of the risk of the loan portfolio and you get the deposits basically for free."
These deals can "easily" generate returns on equity of 20% or more, with little risk, Miller added.
'Nice spread'
A case in point: Prosperity Bank (PRSP, news, msgs), which also made KBW's list. In November 2008, Houston-based Prosperity acquired roughly $3.7 billion in deposits of failed Texas lender Franklin Bank from the FDIC.Prosperity agreed to purchase just $850 million of Franklin Bank's $5.1 billion in assets, so it didn't get a loss-sharing deal from the FDIC.
However, the transaction has still been a big boost for Prosperity, according to President and Chief Operating Officer Dan Rollins.
Prosperity invested the deposits it got from Franklin in government securities and made "a nice spread, which is what we do for a living," Rollins said.
The bank has been building provisions for loan losses rapidly this year and the fees it pays for FDIC insurance have shot up. But the bank is still reporting higher earnings.
"You have to attribute that to Franklin," Rollins said.
On Oct. 16, Prosperity reported a 90% jump in third-quarter profit. Net interest income, before provision for credit losses, jumped 34%. That was driven by a 36% increase in average earning assets -- the result of the Franklin Bank deposits and assets that Prosperity assumed from the FDIC.
Prosperity wants to do more of these deals, and Rollins expects there will be ample opportunities.
"Problem assets always lag the economy, so we still have multiple quarters of this cycle to go," he said, recalling the rash of bank failures that started in Texas in the late 1980s.
"From 1988 to 1992, many banks failed in Texas, but the Texas economy was doing quite well in the early 1990s," Rollins said.
'Wild ride'
However, Rollins' last point illustrates the potential pitfalls of investing in the regional bank sector. With big loan losses still to come, some lenders will continue to suffer. Indeed, the FDIC excludes some banks from bidding on failed institutions because they're considered not financially strong enough or have weak management.Regional banks are particularly exposed to commercial real estate, including construction and development loans. These assets are considered by some analysts to be the next source of major losses for the banking industry. See related story.
Construction and development loans are usually large, and losses on these assets can appear unexpectedly for investors -- unlike residential mortgages where loss trends are more predictable. Synovus Financial (SNV, news, msgs) , which has large exposure to commercial real estate, may continue to suffer heavy loan losses, said Stuart Plesser, an analyst at Standard & Poor's Equity Research.That means investors in regional bank stocks should prepare for a "wild ride," Plesser said.
This article was reported by Alistair Barr for MarketWatch.
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