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PEYTON N. GREEN, Senior Analyst with FTN Midwest Securities Corp, is a graduate of The University of the South where he received a BS in Natural Resources in 1993.

TWST: These are interesting times for the Midwest banks. Where do we stand?

Mr. Green: I think that's absolutely true. Over the past two weeks we have seen tremendous volatility, with stocks re-testing January lows, only to bounce back by 10%-15% a week later. Investor sentiment remains quite negative, with most bank stock aficionados concerned about the unraveling of a recession like the one that crippled bank stocks from 1989-1991.

We believe the trading pattern will remain very volatile based on the natural flow of good and bad news. In our opinion, this is still going to be a year where credit quality deteriorates over the course of the year. I don't think in the past two quarters that the banking system has recognized all the credit quality issues that have developed from the sins committed over the past five or six years; also, it will take the banking system, and financial services in general, reducing the leverage inherent in their balance sheets. The amount of leverage usually increases when very good economic times persist for a number years. For the vast majority of banks, credit losses have been benign for the past 15 years and nonexistent for the past three or four years. Therefore, it is not too surprising that credit underwriting practices have become a little more lax or that pricing has been squeezed to exclude much of a credit risk spread. Clearly, the oversupply of residential housing, coupled with softer consumer demand, will likely weigh on real estate values for the better part of this year. As a result, I think we are going to see everybody's earnings results reflect at least a normal credit environment. For a group of others that were particularly aggressive in growing their residential construction and development lending businesses, we will see very significant recapitalizations and regulatory action. The market seems to be assuming that, given that we've basically seen the typical bank stock fall by 30% or 40% over the past year. The handful of bank stocks that have held up the best reflect minimal concern about a) the strength of their capital, b) their credit quality, and c) the liquidity of their balance sheets. The Midwest, oddly enough, has quite a few of those banks, particularly if you exclude Michigan and Ohio. Again, excluding Michigan and Ohio, the Midwest should weather the forthcoming credit quality storm relatively well compared to the West Coast and parts of the Southeast. In the Southeast, banks in Georgia and Florida will show dramatic deterioration in their credit quality, given the significant overbuilding of residential housing and lot development in their markets.

TWST: The stocks have not done well, but from an operating point of view, how much of the damage have they accounted for at this point or is that still impossible to know?

Mr. Green: I think it is still hard to know for sure. Again, our primary thesis would be that credit quality continues to deteriorate over the course of this year. So far, although it is early, banks that have more recently gone through regulatory exams have been forced to recognize issues sooner than those that have not. In some cases, the same banks received strong marks in their previous exam a year to 18 months ago. However, the economy is weaker and regulators are reacting. They are taking a far more intensive tone, which is probably a more realistic one, in terms of how banks should be administering credit and how they should view the chances of getting paid back on certain credits that are in more stressed areas of the economy.

Construction and development lending is the primary component of most banks' loan portfolios that the market and regulators are most worried about. In particular, the present concern centers on residential construction and development lending, while the more forward looking eye would see issues with commercial real estate construction and development a year or so from now. That's true almost no matter what region in the country you are in.

TWST: Everybody is paying attention.

Mr. Green: Absolutely. I think you are going to see more issues as banks go through the examination cycle. If they had an exam a year ago, they won't get one again until the fall of this year. It depends when they come by to see you. In general, I think bank management teams are starting to become more realistic about the fact that collateral values were too high a year and a half ago and two years ago versus the consumer's income that could support the project. As a result, we are basically seeing a buyer's strike in most markets. Meanwhile, the evaporation of speculative buyers in some markets, like Florida, Nevada and California, have made the markets look like they are at a standstill compared to the go-go days of 18 months ago. Anecdotally, most buyers have been sitting on their hands, waiting to get a sense about the spring selling season, or their own individual economic situation, before buying. Over the past three months or so, most residential builders we have spoken with have become more concerned about the spring selling season. A weak one will probably result in more foreclosures and write-downs by banks.

TWST: How much of this issue can be laid at the door of the bankers and how much at the door of the regulators and the accountants?

Mr. Green: There is always enough blame to go around. When you have five or six years of negligible credit losses, it is human nature to feel very good about your own credit quality and what you are doing. Also, construction and development loans that might have a typical maturity of two to two and a half years, were closing in 18 months to two years. The loans became shorter than what was expected or normal. Now we are seeing the reverse; that is, loans are extending. Today, once a project is complete, only a portion of the pre-sale contracts are closed on by consumers in contrast to the whole development. Basically, banks have become inventory lenders on these projects rather than project financiers.

Without a doubt our government is trying to do their best to get Fannie Mae (FNM) and Freddie Mac (FRE) in a position to facilitate conforming residential mortgage paper. But let's face it, there has been a ton of real estate appreciation over the years, which has turned a lot of properties into jumbo loans. Over time, the seizing up of the jumbo residential mortgage market probably presents a great opportunity for smaller regional banks and community banks to grow. Considering that, they can look at the individual borrower, and say, "Okay, this is a loan we'll keep on our balance sheet, because we don't see much credit risk and we are getting 100, 125 basis points more than we can get on a conforming mortgage for a credit that's actually better." I think banks will get paid more for the risk to take on that kind of business.