The bank industry as a whole has rebounded from its loan problems, said David Berry, director of research for Keefe, Bruyette & Woods.

The bulk of the benefits from declining credit costs have already shown up in most bank's earnings.

But some banks are still digging out from under mountains of bad loans, and their declining credit costs will fuel earnings.

These turnaround banks, along with banks that are likely to be bought, are the best bets for investors, said Mr. Berry, who has spent eight years at Keefe Bruyette.

His top choices: Citicorp, Chase Manhattan Corp., and Midlantic Corp.

Q.: You've become more selective in your approach to recommendations. Why?

BERRY: To make money in the banks today, there are two themes we are interested in. One relates to consolidation, the other to turnaround stories.

If you can invest in a bank that gets in the way of an acquirer, that's good and it's always been good. We follow 150 banking companies. Every year, of the 10 best price performers, seven or eight are takeout plays.

Consolidation will continue. The revenue picture will be tough for banks over the next two or three years. Loan growth is not strong anywhere in the

An acquisition is a way to buy a revenue stream. For the acquirees, it may be more appealing to phone Banc One and find out what they can Offer than to slog it out on their own.

To get shareholders' attention. acquirers have to offer 20% premiums to the market price,

Q.: Who are your takeover favorites?

BERRY: The list is about as long as your arm. Many aren't attractively priced at a given point in time. They are names you want to be familiar with so you can step in when the market gives you the opportunity.

Some of the names we like are St. Paul Bancorp in Chicago and Provident Bank in Cincinnati. We also like the New England savings banks, particularly Medford Savings Bank, in Medford, Mass.

Q.: There aren't many turnarounds left to play, are there?

BERRY: That's true. Most turnarounds have already turned -- the New England banks, for example.

I have a credit-cost ratio in which the numerator is the loan loss provision and foreclosed property expense. The denominator is the risk assets -- the ones causing the losses -- the total outstanding loans and the the dollar amount of foreclosed properties.

According to my calculations, credit costs were subdued in the late 1980s. started climbing in 1990, peaked in 1991, and came down in 1992. By the first quarter of 1993, they were back to where we were in the late 1980s.

The second quarter credit costs were even lower. Credit costs are about where they were before this whole real estate and recessionary debacle.

Q.: Is Citicorp your top choice?

BERRY: Citicorp is the monster turnaround story. It has more potential for turnaround than any other bank we follow.

Citicorp's operating margin -- its earnings before credit costs -- a few years ago ran about $1.2 billion. What Citicorp did in 1991 and 1992 is reduce costs.

They took the headcount down by 14,000 people, or 15%. Citicorp's overall expenses were down 6% in 1991 and 6% in 1992. The operating margin is up to $1.8 billion or $1.9 billion.

That improvement is not well appreciated because credit costs t have soared over the same period. They've had to build up loan loss reserves.

But credit costs have been coming down for the past one and a half years. Consumer loan writeoffs peaked about a year and a half ago, so did real estate

writeoffs.

Q.: What happens to Citicorp after the credit costs come down?

BERRY: Citicorp didn't fundamentally alter what they are. They are still a global consumer bank. They are the largest credit card issuer in the United States by a factor of three. They are one of the largest global wholesale banks and the largest foreign-exchange trader in the world.

That's why there is so much turnaround potential. Citicorp will earn about 18% on equity and 1.10% on assets next year, which it has never done before.

We think Citicorp is a $40 stock by yearend and a $50 stock by the end of 1994.[Shares closed at $35.875, unchanged Tuesday afternoon.]

Q.: If Chase is indeed turning around, it hasn't been noticed by investors, has it?

BERRY: Chase in some ways is the stealth story of the group. No one has focused on this. The stock's market-to-book is low at 106%.

Like Citicorp, the credit-cost improvements haven't shown up because they've been masked by all the problems in their real estate area.

In the second quarter, even with the segregation of real estate assets into the held-for-sale portfolio, their credit costs are still higher than the average bank by a long shot. There is still a lot of room for improvement in credit costs over the next several quarters.

Chase has let go about 19% of its headcount since mid-1990, when Tom Labreque took over.

They made a decision that to the extent they are in the consumer banking business, it is limited to the U.S. Anything not in the U.S. has been sold, shut down, or restructured.

Our per-share earnings estimates are about $1.35 this year, $4.65 in 1994, and maybe $5.50 in 1995. We have a $45 target price in 12 months.[Shares traded at $35, down $1.25, Tuesday afternoon.]

Q.: Midlantic isn't exactly a favorite, either.

BERRY: This was on the American Banker list two years ago of six banks most likely to fail. [The others were Bank of Boston, Shawmut National Corp., MNC Financial, Southeast, and First City Bancorp.]

Midlantic has done a lot of the right. things since then. They have new management in Garry Scheuring. They built up loan loss reserves, and aggressively managed the problem, assets.

Nonperforming assets have been coming down for the past few quarters and they did bulk sales earlier this year to accelerate that process. They anticipate material. reductions in costs for several quarters to come. And they've gone after their cost base.

Even today, credit costs at Midlantic are quite high relative to their history and to other banks. In the late 1980s, its credit costs were about average. They won't get back to normal until 1994.

Because of the bank's large losses, they have unutilized tax benefits. As Midlantic's profitability improves earnings will be untaxed, which will lead to a rapid growth in book value. We project that by the end of next year, book value will be $25. Today its $18.56. That will play into how people value the stock. Our 12-month price target is around $35. [Shares traded at $26.50, down 37 1/2 cents, Tuesday afternoon.]

There's another reason to buy Midlantic: This is a large New Jersey bank, and we think it is a likely consolidation play in the future.

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