From the February 2008 issue of Research Magazine • Subscribe!

Better Credit Quality

There are investment opportunities for those willing to do their homework in the banking sector in 2008, analysts say.

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Samuel Caldwell, CFAKeefe, Bruyette & Woods404-231-6542scaldwell@kbw.com

Outlook: We believe that the core-funded components of the KRX, the KBW Regional Bank Index, are among the most profitable and best performing components of the KRX. In 2007, these names have outperformed the balanced and non-core funded banks by over 1500 basis points. We define core funding as tangible equity and non-CD deposits as a percentage of tangible assets. Core-funded banks have at least 60 percent of tangible equity and non-CD deposits funding their tangible asset base.

We believe these banks also display above-average profitability and have greater value in their respective deposit bases. The core-funded banks in the KRX have an average ROA of 1.44 percent over the last 12 months and an average ROE of nearly 14 percent. Return on tangible equity is even better at nearly 23 percent. Net interest margin is also better for core-funded banks, as the average NIM for core-funded banks was 4.47 percent versus 3.63 percent for balanced-funded banks and 3.12 percent for non-core funded banks.

Interestingly, we also see better credit quality from core-funded banks, with NPAs (non-performing assets) at 0.43 percent of loans versus balanced-funded banks at 0.61 percent and non-core funded banks at 1.57 percent of loans. Core-funded banks also have slightly higher capital levels and higher reserves as a percentage of loans.

The core-funded components of the KRX include Bank of Hawaii (BOH), Boston Private Financial Holdings, Inc. (BPFH), Commerce Bancshares, Inc. (CBSH), Cullen/Frost Bankers, Inc. (CFR), City National (CYN), First Community Bancorp (FCBP), Prosperity Bancshares, Inc. (PRSP) Sterling Bancshares, Inc. (SBIB), Signature Bank (SBNY), SVB Financial Group (SIVB), Trustmark (TRMK), UnionBanCal (UB), Umpqua Holdings (UMPQ), Westamerica Bancorporation (WABC) and Whitney Holding (WTNY).

Core-funded banks also have performed well historically. The banks in the group with the highest core-funding mix had by far the best five-year total return at 56.4 percent on average. The banks in the middle group had an average total return of 18.2 percent for the five-year period, while banks in the group with the lowest core-funding percentage had an average total return of 11.9 percent for the five-year period.

Even given the risks of continued rate cuts, core-funded banks are still the more profitable, less risky, better long-term investment, and more likely to outperform near term than less core-funded peers.

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Manuel Ramirez, CFAKeefe, Bruyette & Woods415-591-5072

mramirez@kbw.com

Sector outlook: Banks look most attractive based on relative dividend yields, in our view. The banks offer a dividend yield that is near an all-time high, relative to the dividend yield on the S&P 500. The relative dividend yield well exceeds that in the early 1990s when many banks cut their dividends.

We think the risk to dividend cuts is important and relatively narrow - that is, the risk is significant but for a limited number of the large-cap banks. The generous dividend yields relative to the market may reflect limited growth prospects for dividends. Additionally, they may signal that more of the total return on these stocks will come from dividends than capital appreciation than has been the case over time.

About UnionBanCal Corp. (UB): We note that asset quality for UB remains pristine relative to peers, with very low charge-offs and non-performers. We have increased our loan growth assumptions to be more in line with management guidance as loan growth exceeded expectations in this [most recent] quarter.

Fee income increased 2.6 percent in the third quarter 2007 over second quarter 2007 due to strong merchant banking fees (up 13.9 percent) and gains in other fee income items. Trading account activities increased by $8 million, while private equity gains declined $8.0 million.

Expenses declined 0.8 percent in the quarter versus our estimate for 1.7 percent growth as a result of lower workers compensation expense and other employee benefit expenses. Outside services fees increased 13.5 percent.

Average loans increased 1.7 percent, driven by a 3.3 percent increase in the construction portfolio, a 4.8 percent increase in residential mortgage balances, and a 2.8 percent increase in commercial real estate.

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