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The bank indexes have held steady in the face of mediocre first quarter earnings and the continued deterioration in mortgage loan credit quality.

The inverted yield curve should make it difficult for banks to earn money since it narrows the "spread" between what banks pay for deposits and interest they earn on loans. But most banks have still been able to meet their first quarter earnings estimates. And surprisingly, non-performing real estate loans haven't been as big a problem for the larger banks as many investors had feared.

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However, looking under the covers of the large-cap bank indexes reveals that many smaller bank stocks are underperforming because these concerns are finally flowing through to the bottom line numbers. I think these smaller banks could be foreshadowing a trend for larger banks as the year progresses. Smaller banks often don't have as many levers to pull as their larger cap cousins and thus, the core trends are easier to spot.

For many smaller banks, net interest margins are compressing, losses are rising and loan growth is slowing - that's the trifecta of bad news for any bank. The negative price action in these small banks is speaking loud and clear, while the indexes are still masking some of the underlying problems.

Here a brief sample of the small cap bank stocks that turned up on my "cheap and beat up" screen. Some of these stocks are already trading close to book value and/or sporting dividends higher than 5%, indicating that the stocks have priced in some serious problems. Value investors can use the list to spot some banks that have been beaten down in the "great mortgage panic of 2007". I haven't done any additional research on these stocks aside from the information that I've pulled up from the press releases and 10-Ks, so I urge you to do your own work if you intend to bottom fish in any of these stocks (lest you buy the next Doral Financial (DRL)).

And if you're not a crazy, knife-catching, bottom-fishing value investor, you should still understand some of the issues these banks are facing because they could soon "flow up" to the mid- and large-cap banks.

Union Bankshares (UBSH)
ubshUnion Bankshares is a multi-bank holding company headquartered in Bowling Green, Virginia. Never heard of Bowling Green? Well, it's right next to Carmel Church. Bowling Green, Carmel Curch? Welcome to the wonderful world of Dr. Seuss, VA.

But despite the location, UBSH is an interesting bank because it's a play on the growth of suburbs around Northern Virginia. The price of real estate remains unbearably high around our nation's capital and more people have moved further out into the rural parts of Virginia. That plays right into UBSH's primary market.

The knock against the bank has been that it's simply a holding company which owns four banks that haven't been integrated. However, it hasn't hurt the strong underlying trends in the company's markets. Loans and earnings have grown over 12% for the past five years.

Despite its strong track record, UBSH missed Q107 earnings expectations for some reasons that will become very familiar to bank investors. The company reported a loss in the mortgage segment, higher expenses and some net interest margin compression.

The company's credit quality remained stellar with just 0.55% non-performing assets to total loans in the first quarter . In addition, net charge-offs have remained minimal over the past year.

While the stock has come down in price, the valuation still reflects some takeover premium. The stock trades at 13x earnings and 2.3x book, both at the high end of regional bank valuations. While UBSH is almost trading at the lower end of the company's historical valuation range, it could still go lower. But the stock would look very interesting at a slightly lower valuation.

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Citizens Republic Bancorp (CRBC)
crbcMidwestern banks have put up some ugly numbers in the last several quarters because the economy in that part of the country is tied heavily to the sagging auto-manufacturing industry. You never know how many loans a Michigan-based bank has made to an auto parts manufacture that is about to have their entire production moved to China. However, despite these headwinds, Michigan-based Citizens Republic Banc has still managed to put up respectable earnings.

In addition to Michigan, Citizens Republic Bancorp addresses certain regional markets in Wisconsin, northeast Ohio, and Iowa. Citizens is positioned as a local middle market/small business commercial and consumer bank in these markets. The company recently closed a merger with Republic Bank, which it is still integrating. Therefore, the balance sheet and earnings have been in flux and a bit difficult to decipher.

Credit quality has certainly suffered from the weak Michigan economy. Non-performing assets were 1.2% of loans, which is at the high end of your typical small cap bank. The company has also had higher than average charge offs. In Q406, net charge offs were 0.53% of total loans.

Still, for as cheap as it has gotten, CRBC's numbers don't look that bad. At an almost 6% dividend yield and trading at 1.0x book, you'd think the company was about to cut the dividend and take a huge loan write-off. While it's a possibility, right now the financial don't indicate that it's highly likely. While the Michigan economy leaves a lot to be desired, the rest of the bank's territory isn't in that bad a shape. Therefore, I think CRBC is an interesting stock at these prices.

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Center Financial (CLFC)
clfcA famous Korean proverb goes something like this - "Cast no dirt into the well that gives you water." But Korean-American bank, Center Financial has done its best to do just that to its valuable franchise.

The company is one of the fastest growing small business lenders in America and has carved a profitable niche in the growing California "multi-ethnic" population.

However, the stock has several serious issues overhanging it. The company recently hired a new CEO who is dealing with "material weaknesses" in the bank's general ledger, which was discovered after an employee embezzled from the company. It's probably why the company's CFO recently "resigned". In addition, the company is facing several serious lawsuits that could crimp the company's capital base were it to lose.

However, growth has remained strong despite management's accounting incompetence and the cooling California real estate market. The company has expanded into the Chicago, IL and Seattle, WA small business market. Both of these areas have growing Korean-American populations.

Credit quality is mediocre with three impaired loans totaling 1.1% of assets and net charge-offs of 0.21% of loans. The bank is currently well capitalized but could face a big reduction in book value if it loses its lawsuits.

Trading at 2x book, CLFC doesn't seem to be pricing in all the negatives quite yet. The strong franchise value might be propping up the valuation but it's too early for me to get interested in the stock - especially with so much dirt in the water.

clfc chart

Irwin Financial Corporation (IFC)
ifcIFC is like the Britney Spears of small cap banks - everyone can tell it has issues - the question now is whether or not it can pull out of its tailspin.

IFC, headquartered in Columbus, IN, has approximately $6.5 billion in assets. The bank operates three major lines of business: commercial banking, commercial finance, and home equity lending. In 2006, IFC sold the majority of the conventional first-mortgage banking business.

As a Midwest bank with a significant exposure to the home equity market nationwide, IFC is facing several tough challenges. The company had been playing the once lucrative "home-equity origination" game with Wall Street -- IFC was originating high-loan-to-equity loans and selling them so they could be syndicated and re-sold by the major bulge bracket investment banks. However, that game came to an end in the past two quarters and IFC has had to eat its own cooking. IFC recently reported that it had to move the loans s that it planned to sell back onto its own balance sheet. This resulted in higher reserve requirements and a mark-to-market loss on these loans. And that resulted in a loss for the most recent quarter.

The second business, commercial banking, seemed to be doing fine until the company announced a large loan write down this quarter. The company wrote-off a $4.2 million loan in its Michigan commercial credit division, confirming what everyone already knew - the Michigan economy is weak. But the rest of the commercial banking business looks OK. IFC has cut expenses to maintain a respectable margins in this business. And the non-performing assets are still very low despite the recent bad loan write-down.

The commercial finance business seems to be the healthiest of the three, with good growth and margins remaining steady. However, commercial finance is usually the least valuable lending business in the eyes of Wall Street.

The stock is trading around tangible book value and has priced in a lot of negative news. However, IFC probably hasn't seen the last of it's earnings disappointments and equity write-offs -- so that book value could simply be a trap door that will fall out from under your feet.

As of today, it's hard to say whether one quarter of rehab will work for the company or whether it will fade into obscurity. But for the value investor who likes watching personal train wrecks play out in public, it's worth keeping on the radar since the stock is so cheap.

ifc chart

BankAtlantic (BBX)
bbxI've always wondered why Commerce Bank (CBH), "America's Most Convenient Bank," is so revolutionary. Why is staying open 'til 8 pm weekdays and all day Saturday and Sunday so groundbreaking? Since when are fast moving lines at the drive thru a new concept in customer service? And why should interest-bearing checking accounts and free coin-counting machines be a revolution in banking? Every bank in America should be able to replicate CBH's model. But they can't do it as successfully as CBH.

Exhibit number one is BankAtlantic in Florida. Bank Atlantic bills itself as "Florida's Most Convenient Bank", an obvious acclamation of its successful counterpart in the north. Like CBH, BBX is open seven days a week, has fast moving lines and pays interest on its checking accounts. But that's about where the similarities end.

BBX has been dogged by high expenses from its rapid branch, or "store," expansion. The bank has been opening new "stores" at a breakneck pace to get a leg up on the competition - namely CBH - which plans on entering the Florida market. The efficiency ratio (non-interest expenses as a percent of total operating income) for a small bank is usually about 45 - 50%. BBX has been running at 90%+. The high expenses have caused the bank to miss earnings estimates for four quarters now. But despite the high expense of opening new "stores" and the resultant weak stock price, management still plans to open about 20 this year. This will continue to put pressure on earnings as most stores don't reach profitability for about 18 months.

Layer on a serious Florida housing bust and you've created a recipe for serious problems. Residential mortgages totaled $2.2 billion in 4Q06 or about 42.2% of total loans. Of this amount, interest-only mortgages comprised $1.1 billion or 50% of the residential mortgage portfolio. In addition, BankAtlantic has $389 million of land development loans (about 7.6% of total loans). None of this is out of line for a small bank, but what makes it troublesome is Florida's collapsing real estate market. The interest only mortgages are a particular problem since the underlying real-estate is probably worth much less now than it was 12 months ago and the borrowers aren't paying off any principal. I think it will be several years before we know how big the real estate mess in Florida really is and how many of the loans turn into charge-offs.

Despite the problems, the stock is interesting because it is trading around book value. If you assume that the earnings are temporarily depressed, the 26x price/earnings ratio shouldn't turn you off automatically. At 1.2x book value, many of the issues are already being priced into the stock. However, the book value could turn out to be a mirage in the hot Florida sun because many of the interest-only and real-estate development loans might have to be charged off. That's the risk.

The stock is worth keeping an eye on because its a takeover candidate. But it's difficult to buy into such a difficult situation without more insight into how bad the Florida real estate bust is going to get.

bbx chart

Popular (BPOP)
bpopPopular has been anything but for shareholders. In the past year, the Puerto Rican-based bank has dealt with a recession in its home country, a meltdown in the subprime home loan market which comprises a significant percentage of the company's loans, and bad investments in mortgage derivatives.

As Puerto Rico's largest bank, BPOP has suffered along with the country's economy. Last year, the Puerto Rican government shut down for two weeks because of a budget crisis, which sent the already weak economy into a further recession. The country and the bank has yet to recover. Credit quality at BPOP has taken a hit and could continue to deteriorate if the country's economy doesn't recover soon.

On top of that, BPOP, like it's country cousin Doral Financial (DRL), made some very bad investments in interest-only strips, which are one of those Wall Street mortgage-derivative products that almost guarantee that the investor will lose money. BPOP has taken several hits on its interest-only strips, including a $34 million write-down this past quarter.

Finally, and most importantly, the company has a high exposure to the U.S. sub-prime market through its mortgage portfolio. The company caters mainly to working-class clientele and over 40% of the company's loan portfolio is considered sub-prime. This obviously increases the risk for continued credit deterioration and further charge-offs.

Given these problems, it's no surprise that asset quality has been weak, with net charge offs running at 0.95% of loans. Non-performing loans also increased this quarter primarily because of the subprime mortgage problems. It seems these problems have yet to stabilize.

There are some bright spots for this decidedly un-popular bank. The company recently recognized a $100 million gain in stock of Telecommunicaciones de Puerto Rico, which ensures the company won't run into serious capital problems in the near term. And the company has built a good franchise of over 100 branches in the US catering mainly to Hispanic and other multi-cultural clients. The demographic trends in New York and California play into the company's core strength.

The valuation is becoming attractive. At 1.4x book value, the stock is interesting if you believe that Puerto Rico could emerge from its recession this year. I have no insight into the working of island economies so I can't take this bet. The company's US franchise also seems valuable if the sub-prime market stabilizes. But that too is tough to predict right now. Given the implosion in Doral Financial (DRL), it's difficult to get excited about BPOP until these issues stabilize.

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First Regional Bancorp (FRGB)
frgbAside from Florida, it seems California has been experiencing some of the biggest real estate bubbles and busts in the past twenty years. As a relatively new bank, FRGB has been a beneficiary of the real estate boom. The company is growing so rapidly that it doesn't even pay a dividend. It remains to be seen how FRGB will do in the bust phase.

First Regional is a $2.0 billion assets community bank based in Los Angeles, CA. The bank specializes in short-term lending for multifamily and commercial real estate properties in Southern California.

The company has significant exposure to both real estate and short term interest rates, both of which have made it difficult for the bank to continue it's strong historical growth. Last quarter, total loans grew only 2% year over year vs. historical growth of over 30%.

Net interest margins have been trending lower and expenses have been trending higher, which caused the company to miss earnings estimates this past quarter. Neither trend seems to be reversing as of the first quarter.

But credit quality has remained strong in the face of a weaker real estate market with no non-performing loans and no net charge offs in the most recent quarter. The company remained adequately capitalized with tangible equity to assets of 7.8% at the end of Q107.

The valuation at 2.0x book and 9x earnings looks tempting, but because the stock doesn't pay a dividend, it's harder to hold if you expect the real estate crunch to last several years.

frgb

Overall, the negative fundamental trends these small cap banks are experiencing could continue until the yield curve steepens and the housing markets stabilize. And the problems these small financial institutions are facing could start appearing in the mid- and large-cap banks as well.

From a technical perspective, many of the stocks have just recently broken down and are still in steep down trends so it could be years until they start recovering. I would expect that these stocks need to build long bases before they can stage a sustained recovery.

However, valuations are becoming attractive enough that value investors should put some of the small cap banks on their radar. With valuations around book value and high dividends, these stocks should find some support if the fundamentals stabilize.

Of the list above, I would expect one stock to collapse into the low single digits and one stock to go back to old highs. Right now, it's just too difficult to figure out which stock is which because the fundamentals are still in flux. Therefore, I think monitoring the stocks is the best alternative.

Source: Beat Up Small Cap Bank Stocks Provide Trading Opportunities, But Tread Lightly