Small banks, big problems

NEW YORK (CNNMoney.com) -- When people start talking about problems in the financial sector, the conversation is often limited to the behemoths in the group.

But there is a vast world outside of New York -- the home base of Citigroup (C, Fortune 500), JPMorgan Chase (JPM, Fortune 500), Goldman Sachs (GS, Fortune 500) and Morgan Stanley (MS, Fortune 500). Ditto for San Francisco (headquarters of Wells Fargo (WFC, Fortune 500)) and Charlotte (domicile of Bank of America (BAC, Fortune 500).)

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In fact, shares of big regional banks in the middle of the country have been pummeled lately. And that may not be a good sign for the economy or markets.

Regions Financial (RF, Fortune 500), a Birmingham, Ala.-based bank with $133 billion in assets, has been among the hardest hit banks in recent days.

Shares have plunged 12% after the company announced its chief risk officer and two other executives of the bank's risk management group were resigning.

Making matters worse, Fitch and Moody's both downgraded several of the bank's credit ratings following the management shake-up. Standard & Poor's slashed its rating on Regions Tuesday to junk bond status.

But Regions isn't the only regional bank taking a beating. Milwaukee's Marshall & Ilsley (MI) is down 10%. Zions Bancorp (ZION) of Salt Lake City has fallen 9%. And a trio of Ohio lenders -- KeyCorp (KEY, Fortune 500), Fifth Third (FITB, Fortune 500) and Huntington Bancshares (HBAN) -- have each tumbled more than 5%.

One of the problems for these regional banks is that the housing market is still a mess. Some worry that the foreclosure robo-signing scandal plaguing the top lenders could lead to another big drop in housing prices and home sales.

That would be disastrous news for all banks, but particularly the regional banks that don't have investment banking or trading operations to compensate for weakness in the bread-and-butter business of lending money and taking deposits.

"If home prices show a meaningful decline, that would bring another round of credit losses, said Terry McEvoy, an analyst with Oppenheimer & Co. in Portland, Maine. "Regional banks are extremely leveraged to the health of the economy."

The latest news on housing isn't encouraging. The National Association of Realtors reported Tuesday that existing home sales in October fell 2.2% from September.

But residential real estate is not the only concern for regional banks. Many have major exposure to commercial real estate. Paul Miller, an analyst with FBR Capital Markets in Arlington, Va., said there's more potential for big losses in that market.

Miller also said that the new round of stress tests announced by the Federal Reserve last week is also hurting some larger regional banks.

The Fed is asking the original 19 financial firms that took part in last year's stress tests to submit plans by early next year in order to prove they have enough capital to meet new international standards. That group includes Atlanta's SunTrust (STI, Fortune 500), Regions Financial, KeyCorp and Fifth Third.

Banks that don't pass the stress test won't be allowed to raise their dividends. The banks also have to pay back TARP in full in order to boost their payouts to shareholders.

Many banks slashed their dividends in the wake of the financial crisis and investors are eager for a return to pre-crisis dividend levels.

But Miller said that smaller banks that don't have to take part in the stress tests will be able to raise their dividends more quickly than the larger regionals that do.

Take a look at Comerica. The Dallas-based bank announced last week that it was planning to double its dividend. And shares of Comerica (CMA) are slightly higher since that announcement. That doesn't seem like a coincidence.

Finally, regional banks may also be struggling due to fading takeover hopes in the sector. McEvoy said that during the summer, some regional bank stocks rallied on the expectation that they could get acquired by rivals for a juicy price.

After all, the M&A market was heating up and many companies in the tech, energy and healthcare sectors were selling out for much more than their market value.

Then, earlier this month, a regional bank deal finally happened. But shareholders didn't exactly make out like bandits. Buffalo's M&T Bank (MTB) agreed to acquire troubled bank Wilmington Trust (WL) for under $4 a share. Unfortunately for investors, Wilmington Trust closed at $7.11 a share the day before the deal was announced.

"There had been some merger talk about regionals and that was starting to get built into stock prices," McEvoy said. "The M&T 'takeunder' of Wilmington removed a fair amount of those takeover premiums."

Miller agreed that the Wilmington deal dashed investors' hopes. But he was quick to point out that the bigger concern is the reason why M&T bought Wilmington on the cheap in the first place.

The day the acquisition was announced, Wilmington also reported a much bigger loss than expected. So it was clear that there were more problems on the bank's books than investors realized. Miller wonders if other negative surprises are lurking in the group.

"What was so shocking about Wilmington was all the hidden crap that was in their results. That's why the froth got taken out of regional banks this quarter," he said.

- The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney.com, and Abbott Laboratories, La Monica does not own positions in any individual stocks.