Sterne Agee is out with a key report discussing merger arbitrage spreads and trends in mergers and acquisitions in the banking sector. While the M&A trade has been on the back burner of late, there have been some developments in the arbitrage spreads for pending M&A deals and in the short interest for the buyers. The firm feels that merger arbitrage spreads seem reasonable at this time, but buying shares of the acquirers could bring higher returns based on such a high building short interest that is happening against the acquirers.

The recently announced PacWest Bancorp (NASDAQ: PACW) and CapitalSource Inc. (NYSE: CSE) merger was called a beacon in an otherwise dim bank M&A landscape so far in 2013 as it was only a $2.3 billion deal total. So far, 2013 looks to register lower in banking M&A activity than the lean years of 2011 and 2012 at only about $9.1 billion in total so far, versus almost $17 billion for each of the past two years. There are only 13 pending transactions that exceed $100 million, and two of these are expected to close imminently.

The M&T Bank Corp. (NYSE: MTB) and Hudson City Bancorp Inc. (NASDAQ: HCBK) transaction is the only pending deal of 2012 vintage due to various regulatory concerns. MTB currently has 9% short interest outstanding and PACW 15%. Another merger covered is the deal between Provident New York Bancorp (NASDAQ: PBNY) and Sterling Bancorp (NYSE: STL), and the balance are simply too small for us to warrant effort.

Arbitrage spreads in general are currently priced around 3.4%, and this is called fairly reasonable, according to the Sterne Agee banking team. Buying the spreads on these two largest transactions would yield about 10.4% and 8.9% on an annualized basis for merger-arb investors.

Sentiment is swinging against the buyers as mergers appear to be the only viable short-term solution to meaningfully grow bank balance sheets. The short interest remains at a fairly high at 6% to 7% of outstanding shares with an average of 17 days to cover.

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