The prior post in this series is here. And before we go much further – two warnings about investing in banks in general.

First – much more than most publicly traded business, a bank’s fate is tied to the local economy (or economies) in which it operates. Because of the amounts a bank borrows, its results are uniquely leveraged to the conditions in its immediate surroundings. To invest in a bank solely because it’s statistically cheap is unwise.

When it comes to investing in small banks in particular, it’s a good idea to have a solid grasp of the main drivers of economic growth and all potential headwinds in that particular area. Since local economies on balance will mirror the national economy, having some knowledge of broader macroeconomic trends won’t hurt, either. As I blabbed on about here, I believe the strength of our current economic recovery, though not great, is not as bad as many pundits seem to think, either. I’ll talk more about Michigan’s economy as relates to Citizens Republic later in this series.

Second, there is no investing in regional banks these days without assuming what could be significant risk in terms of commercial real estate (CRE). Commercial real estate loans simply represent a ton of regional banks’ business. So at the risk of greatly understating this: it’s important to do all your worrying about the loan book upfront, before you buy shares.

One of the reasons I’m looking at banks is that I believe we’re already through the worst in the commercial real estate market. Regardless of my opinion, however, by buying shares in a bank that is already priced for the CRE apocalypse but which has enough capital to absorb it, I can be wrong about CRE and still do well as a long-term investor. I’ll write more about construction and development loans a bit later, too.

I am cautiously optimistic about CRE in that vacancy rates appear to have peaked, hotel occupancy is up, and credit, though not great, is starting to flow again. It also seems highly probable that the CMBS market (which packages and sells CRE loans to big investors) will be up and running in time to absorb the loans coming due over the next two to three years. And while there is no way to prove this, I would suspect that most of the really bad CRE loans were already packaged and sold off to CMBS investors. So, to me, and assuming you’re not sitting on a great big pile of crappy securitized loans, the plumbing in the commercial real estate world looks okay – it’s general confidence that is the issue. Plenty of others disagree with me on this point, however, and they could be right. I simply contend that as long as there is a big enough margin of safety in the shares you buy, in the end it should not matter who is more right.

Lastly – jargon alert! – I’d advise investors tread carefully around banks that don’t consider modified or restructured loans to be non-performing. This practice is also referred to as “extend and pretend.” Just this week the Wall Street Journal finally brought this issue the attention it deserves in the popular press.

Banks can reduce the number of defaulted loans they have to recognize by modifying those loans – extending terms or offering low interest rates. However, history has shown that 50% of all modified loans eventually default. It also can be nearly impossible for investors to identify which banks are extending or restructuring loans which management believes are one day going to fail anyway.

So, loan modifications can make a banks’ books look good in the short-term, but there is a fair chance those problems are really being kicked down the road.

Now I can certainly understand the business case for a bank to hold off on foreclosing on a property. It makes all the sense in the world to extend a loan if it increases the chances that it will be repaid – plus, then the bank can avoid having to sell the property in a deeply depressed market. And I don’t believe all banks are systematically restructuring or modifying loans in an attempt to hide the bad ones. But to not consider restructured or modified loans as non-performing in spite of that historically high level of eventual default seems, mmmm, a bit too conveniently optimistic.

So, I am on you like white on rice, SunTrust Bank.

And good on you, CRBC, for doing the right thing – even if only a few of us are watching.

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