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Date Published: 8/25/09 Hyllandresearch.

Updated 8/27/09

Emerging Trends in Regional Banks
Abstract: Last week, Colonial Bancgroup was seized by the FDIC. With assets of over $25
billion, it was the 5th largest bank ever to fail. In total we have seen 81 banks fail in 2009 and more
than 150 more banks may be in significant trouble. We examine the regional banking industry to
find the next candidates for failure and examine how the FDIC can handle the expected increase in

As the market roars on, the number of bank failures is also increasing. This past week has seen
the 5 largest bank failure in our history. In total, at the time of writing, 81 banks have failed in 2009, a
number not seen since 1992. Recently, an article is out from Bloomberg stating that 150 other banks
may be in trouble based on the ratio of non-performing loans (NPLs) to total loans. The FDIC's latest
quarterly report says that more than 400 institutions are in trouble!

The wild card in the regional banking industry is the FDIC, which is now out of money. The
situation at the FDIC may start a new trend in regional bank deals and closings. Because of the tight
capital strains on the FDIC, it can not burden may more multi-billion dollar hits from bank failures
such as Colonial, which cost the FDIC about 3 billion dollars. It is reported that the FDIC was watching
Colonial Bank as far back as 6 months ago for signs that it was in trouble. Waiting until last week cost
the FDIC significantly more money then if it pulled the plug on Colonial earlier. It is our speculation
that as more banks fail, and the FDIC's funds get closer to 0, we will see an accelerated pace of bank
closures by the FDIC to limit the damage that failed banks do to the FDIC's remaining insurance fund.

To better show the current situation, we look at several graphs released by the FDIC in their latest
So the FDIC has no money, but more and more banks are in trouble which puts more assets at risk.
However, fewer and fewer banks are profitable, so the FDIC raising insurance rates to cover their
shortfall may do more harm than good as those banks are already in the red. Something has to give.
Which Banks are on the watch list? Well, thats confidential. But Bloomberg names a few in their

“The biggest banks with nonperforming loans of at least 5 percent include
Wisconsin’s Marshall & Ilsley Corp. and Georgia’s Synovus Financial
Corp., according to Bloomberg data. Among those exceeding 10 percent, the
biggest in the 50 U.S. states was Michigan’s Flagstar Bancorp.”

Generally, Federal regulators consider anything over 5 percent to be signs of considerable
weakness. Although, it is far from a guaranty that the bank will be shut down.
The article from Bloomberg goes on to list several other interesting statistics. Nationally, of the
7.7 trillion dollars worth of bank loans outstanding in the US, 2.6 percent are nonperforming. This
number is not an all time high though, in 1991 this number hit 3.27 percent as the Savings and Loans
crisis was ongoing. If our current situation is worse and more widespread than the S&L crisis in the
early 90's, we have a long ways to go. And that may mean trouble for a large number of banks.

To start we listened to a couple larger bank's recent conference calls to see what insight they
could offer in our search for vulnerable banks.

Zions Bancorp (NASDAQ:ZION)
Zion is a regional bank that operates in the western US. They have net assets of 58 billion
dollars, and have bought assets from four other failed banks this year. Zion's conference call is a wake
up call to anyone who thinks our economy is in better shape than a year ago.
Some highlights of the call:

To quote the call: “Significant increase in problem loans relative to where we were 6 to 9
months ago...”

An analyst asked “What markets give you the most concern?” To which Zion replied “all of
them...its still a pretty crummy economy” And they added that they are seeing deterioration in all
markets. They highlighted several specific areas of trouble. The entire Northwest, The energy services
in Texas which have lead to problems in housing in Texas and “non real estate” (meaning construction
loans in particular based on other comments during the call).

Zion saw its NPL's (non performing loans) jump 17% to 1.9 billion dollars. Obviously not a
good sign. Zion's total NPA (nonperforming assets) stands at 4.68%.

Another troubling quote from Zion, “further property declines lead to dollar-to-dollar write offs
in Arizona and Nevada”. This comes as data released today shows home prices dropped 19% in
California last month. Arizona, Nevada and California have typically seen similar action in housing
prices. It is safe to say, that Zion is seeing strong decline in property values in Arizona and Nevada still
which may lead to further write downs.

According to the call, Las Vegas and Southern California are the weakest markets they are in,
while Utah and Colorado represent their strongest markets.

Zion's management said the most critical aspect of business for them is the core net interest
margin, which was at 4.09% for the second quarter. That is up .18% from the first quarter of this year,
but down from a year ago. Net interest margin represents the profits they receive from interest on loans
and other investments minus the interest they pay on deposits. This is a key statistic to watch for in
their next quarter's earnings announcement.

The fundamentals on Zion are not pretty, and it is obvious the bank is struggling through the
deteriorating market conditions they are experiencing. However, because of the size of Zion bank, it is
an unlikely candidate for a takeover by the FDIC any time soon. Zion should give investors a chance to
see what next quarter brings before making a significant investment decision.

We are recommending a sell rating on Zion as we see signs of deteriorating market conditions.
Our short term sentiment will change if Zion's share price breaks above $20 as that may indicate the
rally the market has experienced may have more legs.

Next we look at Synovus Bank (NYSE:SNV), which was highlighted in Bloomberg's article for
having a high percentage of nonperforming loans. Synovus is out of Georgia but also operates branches
out of other states including Florida, Tennesse, South Carolina and Alabama.
Synovus has total assets of 34.3 billion dollars of which 6.24% are nonperforming, which
represents a very small decrease from last quarter.

Synovus was asked about performance of their loans based on region by one analyst. Synovus is
seeing a positive trend in the Atlanta housing market, but they said that there are “potentially more
issues out of Floria.” Florida was one of the early states hit by the crisis, and apparently is not through
it yet. As mentioned in previous articles by Hylland Market Research, the real estate market may have a
ways to fall, which puts a lot of banks in danger.

The surprising part of Synovus's call was their expectation to return to profitability by first
quarter 2010. However this seems to be on some overly optimistic assumptions. Synovus is betting
that commercial real estate will not follow residential real estate and will in fact recover soon . Many
are bearish on commercial real estate, and rightfully so. Look at recent earnings reports from
commercial real estate companies, and you will see that the deterioration is not over. If commercial real
estate does continue down, keep an eye on Synovus.

We believe that Synovus may be setting up investors for a disappointment come 2010 and for
that reason recommend a sell rating on Synovus. Our sentiment will change if commercial real estate
begins to recover faster we forecast it to or if Synovus's share price breaks above $5.25. Synovus's
share price has struggled considerably, and is barely above its lows put in during March representing
the bearish sentiment from investors which is shared by us.

Next we look at another company featured by Bloomberg, Marshall & Ilsley Corp. (NYSE: MI)
MI is the largest bank we will highlight, with just under 60 billion dollars in total assets. MI operates
primarily in Wisconsin but is also present in Florida and Arizona. MI is seeing the largest deterioration
in construction and development loans and is working hard to reduce their loans in that category.
Construction and development loans represent 43% of MI's nonperforming loans. Next is Commercial
Real Estate (CRE) loans, which represents 22% of its NPL's. In total 4% of CRE loans are currently

From information gathered by Zion's and Synovus's conference calls, we know that where MI
has lent out the majority of its loans are in areas that others see as very risky and rapidly deteriorating.
MI has taken aggressive actions to reduce its exposure to these areas, however some doubt if it is
enough. Recently an article was published by Dow Jones News questioning if MI is adequately
capitalized. The author, Michael Rapoport writes: “the fair value of Marshall & Ilsley's loans is 10%,
or $4.6 billion, lower than carrying value. Recognizing that would cut deeply into M&I's $5.3 billion of
Tier 1 capital and leave the bank with a Tier 1 ratio of about 1.40%, far below levels that would satisfy

This brings to light an issue that we have not touched on yet, and that is the new accounting
rules and “mark to market”. Banks do not have to show the current value of assets on their balance
sheet, but can instead show what they consider the “fair value”. This rule was recently changed and was
the cause for the sudden turn around in bank's earnings. Look at Wells Fargo Bank for example. It
followed up its worst performing quarter ever with its best performing quarter ever. Apparently though,
someone believes it, as the stock has skyrocketed. But these troubled assets are still sitting within many
banks balance sheets and it may only be a matter of time before these loans may be too much for banks
to bear, such as what happened with Colonial Bank.

There are several other regional banks that we would like to bring to investor's attention.
Sterling Financial Corp. (NASDAQ: STSA) is a bank that has 12 billion dollars in assets and
that we believe may be in trouble and may not survive through 2009. Sterling Financial operates out of
Washington state, a state that has seen one of the largest recent jumps in foreclosure rates compared to
the other states. 6.35% of Sterling's assets are nonperforming and we forecast conditions to worsen
through 2009. Our sentiment on Sterling's stock will change if it is able to rally significantly above
$3.50 a share.

Lastly, we want to highlight Western Alliance Corporation (NYSE: WAL). They operate banks
out of Arizona, California and Nevada. WAL has nonperforming assets of around 3%, lower than the
other banks highlighted, but several other parts of the balance sheet may hint of trouble. WAL's non
interest expenses have jumped 24%, indicating trouble controlling expenses. WAL also has seen a large
increase in past due loans, which may be a leading indicator of increased future nonperforming loans.

How do investors play a bearish outlook on regional banks? An investor betting on individual
banks has several options. Simple buying of shares (if bullish) or shorting of shares (if bearish) will
certainly work. However, we prefer to play individual banks with options instead. Many regional banks
have seen a significant run up in share prices and implied volatility has dropped to 52 week lows,
which makes options, specifically put options, on certain regional banks relatively cheap. The difficulty
with options is choosing the right month for expiration of the option. For banks discussed within this
article we believe the January 2010 expiration represent enough time for significant moves in the stock
price, while not costing an investor too much.

For investors looking for a safer approach, there is a regional bank ETF, symbol KRE. Should
the regional banking industry struggle and experience an increase in failures, KRE will certainly fall in
price. An investor shorting, or buying puts on KRE is also more diversified compared to speculative
bets placed on individual banks.

Keep in mind the increased risks with options and the speculations made in this article. We are
currently in a market where government intervention can come at any moment. That said, we believe
that many regional banks are 'too small to be saved' (as opposed to 'too big to fail') and will ultimately
be taken in by other banks or the FDIC.
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