(Recasts; adds analyst's comments, background, share movement)
April 7 (Reuters) - During the next two to three years, U.S. bank failures will likely increase dramatically from the low levels recorded from 2004 to 2007, as credit problems mount for the industry, a RBC Capital Markets analyst said.
"We anticipate upwards to 150 banks will fail over the next two years. Banks that deplete their capital through rising credit losses are most vulnerable to failure," Gerard Cassidy said.
He said credit problems at U.S. banks are expected to worsen throughout the year from existing levels and are unlikely to peak until sometime next year, also noting that widespread housing deflation will put further pressure on the economy.
"As we move deeper into 2008, we expect to see economic growth grind to a halt with recessionary pressures mounting as the year progresses," Cassidy said, recommending investors "underweight" the bank sector.
Recent aggressive actions taken by the Federal Reserve provide some relief to illiquid credit markets, but do not directly address deteriorating commercial real estate and construction and development credit quality trends, Cassidy said.
He expects an uncertain political environment in a presidential election year, continued deteriorating market fundamentals in the residential market and higher unemployment to force credit costs higher for the U.S. banking industry.
He said any potential recessionary period will only weaken credit quality at commercial banks from current levels, likening current trends to the 1990-91 recession.
In the 1990 downturn for banks, delinquent loans were rampant and reached levels that led to massive bank failures all over the country, he noted.
"In the current downturn we have not even scratched the surface of losses and in many loan categories, we anticipate that additional losses are forthcoming," he said.
"We strongly believe that credit will worsen from present levels spreading from home mortgages into home equity, credit cards, auto, commercial real estate, construction and leveraged loans this year," he wrote in a note to clients.
The analyst also said banks' stock valuations were still expensive, saying that the forward 12-month price-to-earnings ratio for the top 50 banks stand at 13.2 times versus a 25-year average of 10.9 times.
"We believe it remains too early for long-term investors to step in and buy given that bank valuations are still too high relative to our expectations for significant credit deterioration that we foresee extending throughout 2008," Cassidy said.
The Standard & Poor's Financial Sector Index .GSPF has lost about 30 percent of its value since it hit an all-time high in May last year. The index was up 6.05 points to 359.66 on Monday in afternoon trade. (Reporting by Tenzin Pema in Bangalore; Editing by Bernard Orr)