Ah, to be healthy bank that dodged the last financial crisis in residential mortgages and isn’t cowering in fear of the new one in commercial mortgages and loans.

You be hovering up deposits from savers looking for safety. Licking your chops at all the tasty businesses that competitors not as skilful or lucky were selling off at bargain prices. And enjoying the steepest yield curve in 30-years where short-term deposits or borrowing costing almost 0% can be turned into loans prime (currently 3.25%) plus.

Heaven.

Actually, a bank doesn’t have to be quite as pure as the driven snow to enjoy that paradise. You can even have taken a bath in the financial crisis. Issued mortgages to dead-beats unable to pay. Bought your way into businesses you didn’t understand at what turned out to be the peak of the market.

You could have done any and all of that—and still be in a position to clean up on the woes in the financial sector—as long as you’ve recovered more quickly than your peers. So desperate as investors and regulators for anyone to take the worst turkeys off their hands before they turn into billion dollar liabilities that all past sins are forgiven if you’ve got a  balance sheet now that looks strong enough to bear the load.

Banks like these—I’d call them reformed sinners—are to me the most interesting and potentially profitable segment of the banking sector. Because they didn’t dodge all the damage of the financial crisis, they didn’t snap up big deals in the early days of the crisis. So they’re not full up. But now that they have put their sins behind them to emerge as potential “rescuers” rather than candidates for rescue, they’re in a position to pick through what is still a most attractive and still growing pile of distressed financial companies.

I’ve got two banks like this to tell you about in this post. One I’ll add as a buy to Jubak’s Picks with this post. The financial sector is correcting now and it’s a reasonable time to add a financial stock. The other I’m going to put in my Watch List because the financial sector correction might have a way to go yet and what’s a bargain now might become a still bigger bargain not too far down the road.

(And by the way, I’ll be launching a formal watch list on this blog, following much the same format as one of my portfolios, in January. A number of readers have asked for a watch list, saying that it would help them keep track of potential buys. I think it’s a good idea so I’ll have it up as soon as the wonderful people I work with can get it built.)

Here’s why I think reformed sinners are the best buys in the financial sector right now.

Regulators and worried investors have already tapped the most visible survivors of the financial crisis and banks such as JPMorgan Chase (JPM) are sitting back, stomachs full, still trying to digest the assets they “rescued.” JPMorgan Chase, for instance, acquired most of Washington Mutual for $1.9 billion to help out the Federal Deposit Insurance Corp. (FDIC). That deal expanded JPMorgan Chase’s market share in California but on top of the acquisition of Bear Stearns and the still ongoing integration of BankOne, I’d have to say that JPMorgan is done “rescuing” troubled financial companies for a while.

That means investors and Wall Street analysts are looking at something like a finished product. The JPMorgan Chase to a year from now will be different from the JPMorgan Chase of today but in ways that are relatively predictable. The changes will be continuations of current trends. The company will integrate and rebrand acquisitions, get costs out, port products from one unit to another to create a uniform selling proposition, and build market share in key businesses by exploiting the base gained in these deals.

Nothing wrong with predictability, especially when current trends are running so strongly in JPMorgan Chase’s favor, but since, with a little intelligent extrapolation, what you see today is what you get tomorrow, the stock is likely to be more accurately priced by the market for its level of risk.

“More accurately than what?” you ask. Than reformed sinner banks who are still in acquisition, I mean “rescue,” mode, I answer.

One of these is U.S. Bancorp (USB). On October 30, the bank helped out the FDIC by rescuing nine banks with $18 billion in assets and 150 branches in Texas, California, Illinois and Arizona that had belonged to FBOP Corp. of Oak Park, Illinois. (U.S. Bancorp subsequently sold off the three Texas banks it has acquired as part of this rescue.) Just weeks before that, in another transaction U.S. Bancorp acquired $800 million in deposits in Arizona that BB&T (BBT) had recently acquired in another “FDIC facilitated transaction.”

I think you get the idea.

There’s no reason to believe that U.S. Bancorp is done—because the FDIC isn’t done facilitating transactions. The agency’s list of troubled banks climbed to 552 at the end of the third quarter. That’s up from 416 at the end of the second quarter. That’s the largest the troubled bank list has been since December 31, 1993 when, in the middle of the savings and loan crisis, the troubled bank list hit 575.

The troubled bank list this time around could still challenge the 1993 numbers. The banking crisis, rather than being over, has simply shifted focus. In 2008 and 2009 the crisis was all about residential mortgages and the derivatives built on them. That stage in the crisis isn’t by any means resolved—mortgage foreclosures will hit a new record in 2009 (see my December 10 post https://jubakpicks.com/2009/12/10/household-wealth-and-foreclosure-rate-both-rise-what-kind-of-recovery-is-this/)

But the crisis now expanded to loans and mortgages on commercial real estate—you know loans on malls, hotels, condominium developments, etc. Projections say defaults on these loans will be on the rise into 2011 at least.

Which is extremely troubling since the default rate on these loans had already reached a 16-year high of 3.4% in the third quarter of 2009. According to Real Estate Economics, defaults could hit 5.3% within two years.

The names you’re likely to hear in this commercial real estate phase of the financial crisis aren’t the big boys like Citigroup (C) and Bank of America (BAC) who played starring roles in the residential mortgage crisis. The commercial real estate crisis is focused at regional and community banks. Not only did they make lots and lots of these loans to local real estate developers but these loans make up a huge proportion of their portfolios. According to data compiled by Bloomberg, these smaller banks have about four-times the concentration in commercial real estate as the portfolios of the biggest U.S. lenders.

The size of the banks that are likely to be in trouble over their commercial real estate loans works to U.S. Bancorp’s advantage too. Acquiring one of these banks or a bunch of its branches and a hunk of its deposits is small change to a JPMorgan Chase. The deal is too small to be a game changer. That company needs a deal like its acquisition of Washington Mutual, which added 2300 branches to move the needle.

U.S. Bancorp isn’t tiny by any means but with just 2,800 branches in the United States, adding a few hundred branches here and a few hundred has a bigger relatively impact on the bank’s bottom line. And especially on its strategy of funding its lending by gathering deposits. A bank’s ability to grow its deposit base depends on its ability to dominate geography with branches and its brand.

Reformed sinner banks aren’t limited to the United States. HSBC (HBC), for example, is a reformed sinner that is using this crisis to increase its already formidable presence in Asia.

HSBC sinned deeply and fell hard in the crisis. The company spent $15 billion in 2003 to buy Household International in order to enter the U.S. mortgage market. The timing of that deal was just right so that HSBC could get hammered in the U.S. housing bubble and bust. Actual write downs from the Household International business were about the same as what HSBC had paid to acquire the company.  The math of that deal turned into paying $15 billion to buy $15 billion in losses.

But reform took hold of HSBC hard in 2009. The bank closed its U.S. consumer finance unit to new business in February 2009 and to close its 800 HSBC branches that specialize in consumer lending. The bank has been running down its $62 billion U.S. consumer lending portfolio since then. In April the bank raised $17.7 billion in capital through a stock offering that it used to buttress its capital ratios. And finally HSBC CEO Michael Geoghegan has announced that he will be moving his office to Hong Kong from London. That’s a very visible affirmation of the bank’s decision to return to its Asian roots. Hong Kong and the rest of Asia accounted for 26% of the bank’s assets at the end of 2008.

That percentage looks like to rise now that HSBC has emerged as the front runner to buy the Asian assets of troubled Royal Bank of Scotland (RBS). Those assets looked like they would go to Standard Chartered (SCBFF) earlier in the year but that bank and Royal Bank of Scotland couldn’t come to terms. On December 10, the Financial Times was reporting that HSBC was close to striking a deal with Royal Bank of Scotland for the sale of 28 branches in India and 13 in China. In March Royal Bank of Scotland posted the biggest loss in United Kingdom corporate history. The bank is now majority owned by the government.

The Royal Bank of Scotland stake in Asia isn’t the last set of assets that troubled United Kingdom, European, and Middle Eastern banks will have to put up for sale. And HSBC will be there to make a go at any distressed asset sale.

With the Chinese economy set to return to 10% economic growth in 2010—how sustainable that is for the long term is another story—and with Chinese exports likely to return to growth this quarter or next (see my post https://jubakpicks.com/2009/12/10/when-will-chinas-currency-strart-to-climb-against-the-dollar/ ), owning a bank that owns an increasing bit of Asia’s banking business seems like a good investment.

I’m adding HSBC to Jubak’s Picks with this post. I’ll post a full buy spelling out my logic in more detail later today.

Full disclosure: I own shares of HSBC, Standard Charted, and U.S. Bancorp in my personal portfolio. I will buy more shares of HSBC three days after this is posted.