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Mid-Cap Lenders Are Facing Challenges

With the first quarter of 2006 coming toward a close, analysts at Merrill Lynch think that medium-sized banks may find it difficult to continue posting strong stock price gains.

In a recent report, the investment banking firm said that mid-cap banks will likely continue to report weakness in their business fundamentals. Moreover, Merrill Lynch believes "most banks will miss expectations" and fail to report year-over-year growth. That will put pressure on the stocks of mid-cap institutions, making it difficult for the sector to hold onto recent stock gains.

"We believe deteriorating fundamentals will eventually win out over interest rates and consolidation speculation as the primary drivers of stock price performance," Merrill Lynch analysts Heather Wolf and Stephen Austin said in their report. Overall, they expect first-quarter trends to include modest compression of interest rate margins, slowing loan and deposit growth, increases in credit costs, slowing fee revenue growth and deteriorating efficiency rates. One factor limiting fee-income growth is the slowing of mortgage lending volume, Merrill Lynch said.

Factors that may drive up credit costs include deterioration in auto loan portfolios, some commercial real estate loans and higher losses related to Hurricane Katrina.

The analysts say that takeover speculation, already baked into stock prices, may be "overdone." It's unlikely that merger and acquisition speculation will continue to push stock prices higher. Currently, the valuations of small and midsized, publicly traded banks are "persistently high," the report said. They note that the KBW regional bank index, which tracks primarily mid-cap and small-cap banks, is up 10% so far this year.

But Merrill Lynch says that recent deals like Capital One's acquisition of North Fork are not harbingers of a string of additional deals, though they concede that consolidation will continue in the banking sector.

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