We think that the worst of the credit crisis is now probably behind us, but the banking system is not yet out of the woods -- there are still many significant challenges ahead. The banks are now able to tap the debt markets without the FDIC’s support, and also access the equity markets as the investor confidence returns in the stronger banks. Many banks have already repaid the TARP funds to the Treasury.

While the bigger banks benefited greatly from the various programs launched by the Federal Reserve, the Treasury and the FDIC and are now in much better shape, many smaller banks are still in a very weak financial state and the FDIC’s list of problem banks continues to grow. Further, government efforts have not succeeded in restoring the lending activity at the banks. Lower lending activity will continue to hurt margins, though the low interest rate environment should be beneficial to the banks with a liability-sensitive balance sheet.

For the last few quarters, the banks have mainly suffered due to the losses in mortgages and Commercial Real Estate (residential construction loans). Housing prices have continued to decline, and given the sharp increase in the level of unemployment we anticipate continued losses in these portfolios. Further, deterioration in other Commercial Real Estate loans is now rising at a rapid pace and the downturn in this class is also likely to be very challenging.

With the deterioration in the overall economic environment and rising job losses, we anticipate the losses will continue to increase in all the other asset classes as well, especially in consumer-related loans. It was recently reported that U.S. credit card delinquencies rose to a record high and are expected to rise further. We expect the asset quality deterioration to continue at least through the end of FY09.

As a result of rise in charge-offs, the levels of reserve coverage have fallen over the past quarters and the banks will have to make higher provisions in the coming quarters, affecting their profitability. Despite increased provisioning over the past several quarters, the ratio of allowance for loan losses to non-performing loans dropped to 70% at March 31, 2009 from 100% a year ago.?As a result of these substantial asset quality deterioration and the need to build reserves further, many banks will continue to be unprofitable in 2009.

OPPORTUNITIES

We recently upgraded our recommendation on Ocwen Financial Corp (NYSE: ) to a Buy, as this company could be a major beneficiary of the President's Home Affordable Modification Plan, which provides incentives for loan modifications to the borrower, the investor, and the servicer. OCN was appointed by a major GRE as one of the servicers for the new pilot initiative launched to identify borrowers who are at a risk of foreclosure. Recently the Treasury extended TALF to include securities backed by servicing advances, which will provide comfort on the liquidity front.

WEAKNESSES

Banks with high exposure to housing and Commercial Real Estate loans, like Wilmington Trust Corporation (NYSE: ), KeyCorp (NYSE: ) and Zions Bancorp (NASDAQ GS: ) will continue remain under pressure.

We also maintain Sell recommendations on Freddie Mac (NYSE: ) and Sallie Mae (NYSE: ) as we anticipate rising losses and increased provisions during FY09.

Zacks Investment Research