Since 2007, it's seemed like the banks just can't catch a break. Looming losses in commercial real estate are the latest dark clouds to hang over the industry. Given the continued troubles, should you invest in regional banks now?

Perhaps. But as with any investment, there are pros and cons.

First, the cons
It's impossible to deny that the regional banking space is challenged at the moment by the economy and commercial real estate. Mark Fitzgibbon, an analyst at Sandler O'Neill & Partners who covers regional banks, says he thinks the industry will continue to grapple with commercial real estate for the next several quarters. "As commercial real estate borrowers are being forced to refinance their loans," Fitzgibbon says, "they're having fewer and fewer places to go to do that, because the securitization markets and the conduit markets are closed."

Morgan Stanley analyst Ken Zerbe, who covers mid-cap regional banks, also says he expects a prolonged commercial credit cycle and doesn't expect mid-cap banks to return to normalized earnings levels until 2012.

Now, the pros
Fitzgibbon points out some good news: Although commercial real estate is a big asset class for regional and community banks, he expects the severity of losses in most of the commercial real estate loans to be much less than what we've seen on the construction or residential mortgage side.

Zerbe, in turn, says credit is starting to show signs of stabilization, with nonperforming loan losses slowing.

Core banking operations are also doing well, according to Fitzgibbon. He says the industry tends to do well with a steep yield curve environment, and we have a historically steep curve right now. "You're seeing strong margins, but at the same time, because the environment is so challenging, banks are becoming more efficient than they ever were, because they need to squeeze every last dollar out of their business," Fitzgibbon says.

Zerbe offers a similar positive outlook, saying that banks are still trading near or even below their tangible book values. He projects that many mid-cap bank stocks will see "material upside" over the next 12 months as investors start to "look through the credit cycle."

But is it worthy?
Fitzgibbon uses five metrics to determine whether a bank is investment-worthy:

  1. Look at non-performing assets relative to assets. Generally, you'll want to see companies that have less than 2.5% or 3% in non-performing assets.
  2. Look at 30-to-89-day delinquencies for clues about souring loans. This will give you an early warning sign of problems that might be percolating in the portfolio before they actually go non-performing.
  3. Does the bank have enough capital to weather the storm? Look at the tangible capital ratio.
  4. How much has the bank put aside in reserves to deal with problem loans? Look for loan-loss reserves (as a percentage of loans) of 1.5% or higher.
  5. Look at a valuation metric. The one valuation metric that works right now is price-to-tangible book value. (P/E is not relevant at the moment, because most of the companies in the industry aren’t making money.) Look for companies with a tangible book value of less than 1.4 or 1.5. Fitzgibbon says there are many companies that are below book value right now. "If you go back three years and you look at the banking industry, there were only two banks that were trading below tangible book value," he says. "Today, there are over 400."

Investors should also be cognizant of the bank's management team and the area of the country in which the bank operates. The economic picture is radically different in the Northeast than in South Florida, for example.

6 to start
Fitzgibbon favors the strategy of buying banks that are themselves in a position to buy failed banks from the government cheaply, or to buy distressed companies at very low valuations.

The analyst likes banks in the Northeast because the economy is stronger there, meaning investors can eliminate credit-quality concerns present in other sections of the country.

Specifically, Fitzgibbonfavors Hudson City Bancorp (NASDAQ:HCBK) because he says it has been unaffected by the current difficult credit environment and has been able to generate a return on capital in excess of 10%. "They are the most efficient bank in the country," Fitzgibbon says. "And in a commodity business like banking, efficiency is key. They have an efficiency ratio of 19%, whereas the rest of the banks on average are around 60%."

Fitzgibbon also likes Berkshire Hills Bancorp (NASDAQ:BHLB) and Danvers Bancorp (NASDAQ:DNBK), which the analyst says are well-positioned to be consolidators. He approves of the creative management teams at both banks, which he says have seized on opportunistic acquisitions (and which may continue to do so). The analyst also notes that both banks' credit quality is much better than their peers.

Finally, Fitzgibbon favors Provident Financial Services (NYSE:PFS) because it has lots of capital and a bright management team. Fitzgibbon says the bank has also been relatively unaffected by the economic downdraft and is benefiting from a steeper yield curve.

As for Zerbe, of Morgan Stanley, his top buy-rated regional banks include Hudson City, Webster (NYSE:WBS), and Zions (NASDAQ:ZION). The analyst's top underweights include Cullen/Frost Bankers, M&T Bank (NYSE:MTB), and Westamerica Bancorp.