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Barclays Capital Israel investment house has downgraded its outlook for the Israeli banking sector to Negative.

The firm, formerly the research department of Lehman Brothers Israel, predicts that like banks everywhere else, Israeli banks will to have to cope with an onerous economic environment this year. The uncertainty is exacerbated by the inability to predict the magnitude of provisions for doubtful debts, which rose sharply in the third quarter of 2008.

Even so, Israel's banks are not facing the same problems as banks abroad, so they are expected to achieve better returns than banks overseas despite the economic downturn.

Within the sector, Mizrahi Tefahot Bank has been awarded an Outperform rating by the head of Barclays Capital Israel's equity research department, Joseph Wolf, who has slapped an Underperform rating on the three large banks - Leumi, Discount and Hapoalim.

Barclays favors Mizrahi Tefahot because its strong focus on retail banking and 30% share of the mortgage market puts it in a better position than the rest of the sector during an economic slowdown. Barclays believes Mizrahi Tefahot's stock will outperform both the other Israeli banks and the broader market indexes.

The analysts note that in 2008 Mizrahi Tefahot's stock was the eighth best-performing share on the large-cap TA-25 index. The bank's share lost 34%, while the index fell 46%. In the previous slowdown, Mizrahi Tefahot's stock also outperformed.

Another factor in Mizrahi Tefahot's favor is the transition to the Basel II Accord, which will free up some of the bank's capital thanks to lower capital-adequacy requirements for mortgages.

In his review of Hapoalim, Wolf explains that the bank's stock lost more ground in 2008 than Leumi due to the heavy losses from Hapoalim's investment in mortgage-backed securities. Even after the sale of its MBS portfolio, Hapoalim still faces some big challenges.

Wolf notes that the bank seems to have put on ice for the time being its 15% return-on-equity goal for 2009. Considering the high capital-adequacy requirement Hapoalim will have to meet, Wolf figures the bank will not pay a dividend in 2009.

Barclays has set a 12-month price target of NIS 10 for Hapoalim shares, or about 23% more than the stock's price on the Tel Aviv Stock Exchange yesterday.

Wolf says Leumi's core activities are likely remain stable in 2009 and that the share price will be affected by the bank's holdings and their structure. Barclays figures that the share could be stung if the bank has to sell its holdings in Migdal Insurance and Paz Oil.

If the Cerberus-Gabriel group of hedge funds decides to sell its stake in Leumi, the bank's stock would probably lose ground. Wolf's 12-month target price for Leumi is NIS 11, or about 30% more than its market price yesterday. Even so, Wolf has given the stock an Underperform rating.

As for Discount, Wolf notes the bank's low capital-adequacy ratio, which sank to 10.6%, compared with an average of 11.5% at its competitors at the end of the third quarter.

Other factors likely to weigh on Discount's share price are costs for the bank's streamlining program and its holding in American subsidiary I.D.B. New York. Despite these negative factors, however, Barclays does not expect a drastic drop in the stock.