Shares in a number of far smaller, more focused regional banks have held up quite well during the crisis. "This is due in large part because the mortgage crisis has impacted certain regions [e.g., Florida, Arizona, Nevada and California] worse than others," explains Anton Schutz, the portfolio manager of the $30 million Burnham Financial Industries Fund.

Schutz's fund, which can short up to 25% of its assets, has realized annualized gains of nearly 8% over the past three years, topping the S&P 500 by 2.7%. Among his largest positions is New Jersey-based Hudson City Bancorp, which made a new high in early February. "The bank maintains high quality loans and a personal lending practice, never securitizing its books," observes Schutz.

He believes the current crisis will be a boost for certain regionals. Money center banks had been encroaching on their turf, underwriting noncompetitive local loans to fuel securitizations. But they are now pulling out of this market. At the same time, bank devaluations may drive consolidation, which Schutz believes is one of the industry's most compelling investment themes.

International Options

Since subprime lending was largely an American phenomenon one may think that most overseas banks should be OK, markets. But some European giants were smacked because they had loaded up with related derivatives. Swiss UBS was tarred by $18 billion in write-offs last year, helping to drive the stock down 50%. While not as badly exposed, Britain's second-largest bank, Barclays, has experienced a similar loss, due in part to a lack of corporate guidance. Meanwhile, the shares of Unicredito, Italy's largest bank, have declined 30% for reasons that appear to be more related to industry and macroeconomic conditions than to any specific exposure.

"Despite holding a greater percent of troubled assets, U.S. firms are ahead of foreign banks in cleaning up their subprime-related mess," says Francis Claro, who runs the Evergreen Global Opportunities Fund, which has appreciated more than 24% annually over the past five years. Aided by more aggressive rate cuts, he believes U.S. banks could recover sooner.

Paul Blankenhagen, who manages the $2.3 billion Principal Diversified International Fund and who has generated annualized gains of nearly 22% over the past five years, agrees, saying, "There's an anticipation of more negative announcements and write-off s to come out of Europe."
Fearful that many of the developed markets are locked in a negative cycle where more restrictive lending will further contract already slowing economies, Blankenhagen is more upbeat on the long-term prospects of East Asian shares. "In Australia, Singapore and Hong Kong," he notes, "lending standards are stable, liquidity is plentiful, GDP growth continues on a steady footing. In addition, banks like Westpac, Overseas Chinese Bank Corporation and Hang Seng Bank rely less on higher-cost wholesale funding than do large Western banks. As a result, they've experienced less margin erosion."

The most compelling bank stories are in emerging markets, according to Mark Edwards, co-portfolio manager of the $4.3 Stock Fund, whose five-year annualized returns have exceeded 37%. These economies are being fueled by soaring commodity prices and exports; the outsourcing of production and services; declining interest rates; and growing local consumer demand. In addition, Edwards observes, "Much of the emerging banking industry is modernizing, growing more efficient as firms are weaned off their governmentowned models and transformed into private commercial enterprises."

Five of Edward's top 25 holdings are banks, with his third-largest position being in Brazilian Banco Itau.

Not Just Ordinaries

When the industry does rally, common bank stocks will provide the largest rewards, even though being highly sensitive to corporate and industry news also makes them the riskiest investments. Their tax-qualified dividend yields have grown exceedingly rich, many topping 5%. But as was seen in the cases of Citigroup and Washington Mutual, current yields are far from guaranteed. Big foreign banks tend to be more committed to preserving their dividends, but that doesn't assure payout either.

"Lack of transparency still makes investing in many large banks difficult," explains Dan Campbell, the former head of Merrill Lynch's Hybrid Capital Securities who is now an industry consultant. As an alternative, he suggests looking at convertible preferreds. "These securities are hybrids," Campbell explains, "paying a dividend that's typically more secure and larger than the dividend of ordinary shares." This helps limit the downside, and the yield is tax qualified. At the same time, convertible prices will rise when the common shares rally, thus sustaining a preset conversion ratio into equity.
T. Rowe Price's Arricale likes the Citigroup 6.5% convertible preferred. In early February, it was trading at $53.60, yielding nearly 6%, 275 basis points above 10-year Treasurys. Based on prevailing market conditions, Arricale fi gures that the convertible would capture 9/10ths of the gains if Citi's stock rallied, but would lose less than half what the common gives back if the shares got hit.