The risks of the banking industry and how it is likely to perform in this environment are discussed.
The hardest-hit loan type will be different this time.
Over 95% of publicly traded banks are Community or Regional banks. These differ significantly from the larger money center banks.
The banking industry is in a stronger position than it was going into the last recession, but still quite vulnerable if the Covid-19 virus pandemic lasts past the summer.
It has been Goldilocks times for banks in the last two years. Profits have been strong, loans have grown, interest margins have been solid, and problem loans have been low.
Two items of note have occurred in the past two years. The biggest item was the tax rate cut effective January 1, 2018 reducing the federal income tax rate from 35% to 21%. This had a major impact on the earnings of banks. Since then, earnings for most community banks have increased by 20-50%.
The second item is interest rates. There are two rates that matter most to banks: the daily rate and the 5-year treasury. The daily rate is used for many commercial loans and most commercial and consumer lines of credit. It has been based on the prime rate or LIBOR indexes, both of which are based on the Fed Funds rate. Recently, it was announced that LIBOR would be phased out and the Secured Overnight Financing Rate (SOFR) would be substituted. SOFR is a more market-based rate than LIBOR, which means it is less controlled by the banks. The 5-year treasury is the most common fixed rate used for commercial real estate loans and many commercial term loans. It also has some relevance to the fixed-rate residential mortgage rates and vehicle loans. The 5-year treasury was at historic lows in 2016, dipping below 1%. It then rose in 2017 and 2018, getting just over 3%. This benefitted most banks. In the last month, it plunged to 0.66% as of today. The Fed Funds rate acted similar to the longer-term fixed rates. It rose from 0-0.25% in 2016 to 2.25-2.50% in December 2018. In the month, it has been slashed all the way back to 0-0.25%.
On a longer-term view, the number of U.S. banks have been cut by 46% since 2000. There were 4,561 banks in the U.S. as of September 30, 2019, down from 8,458 on March 31, 2000. Almost no new banks have been granted charters since the last recession, until just the past year or so. However, the industry has gotten more competitive due to expansion of the remaining banks and competition from non-banks. Despite all the mergers, there are still too many banks. Most larger and even mid-sized markets have at least a dozen commercial lenders and often hundreds of residential lenders.
Community Banks Compared to Larger Banks
There are three classifications of banks in this country based on size and geography. Community banks are those with under $10 billion in assets. The next size up is Regional banks. They are over $10 billion in assets but operate regionally. The largest size is Money Center banks, which tend to be even larger and operate nationally and, often, internationally. There are only a handful of Money Center banks. Over 95% of publicly traded banks are Community or Regional, with most of those being Community banks.
Community banks differ from large banks in that they mostly stick to a local geography that they know well. They are almost never involved in the riskier activities used by big banks, such as credit cards, derivatives, foreign loans and services, asset trading, and investment products like managing mutual funds, private equity, and hedge funds. They also have virtually no exposure to the industries currently being most impacted by the Covid-19 pandemic. These industries include airlines, aerospace, oil & gas, mortgage REITs, and retail chains. The Regional banks are mostly like the Community banks, but often are involved in some of the Money Center bank activities.
Because community banks have less risky activities, they generally a higher P/E ratio than large banks. Part of this is also due to industry consolidation. The Community banks are more likely to be acquired than the larger banks, giving them a buyout premium. There has been significant consolidation in recent years and few new banks added. Most bank acquisitions are done with stock, because using cash depletes all important capital. Many smaller banks (under $1.5 billion) are having difficulty competing with the heavy regulatory burden and increasing IT costs. Their numbers are rapidly decreasing, as they have been selling out.
The Covid-19 Situation
The Covid-19 virus has spread rapidly in almost all areas where a lockdown has not been employed. Efforts to battle the virus only got serious in the past week. Most events and meetings of over 100 people have been cancelled. People are just starting to change their lifestyle. Test kits are only now becoming available. The point here is, because of the 1-2 week latency of the virus, it will take another week or two to see if current efforts will slow the spread of the virus. Meanwhile, it is doubling in the U.S. and many other areas about every two days. We know only one thing that has worked – that is a lockdown. The growth of the virus has almost completely stopped in China, the most impacted nation, due to lockdowns. It has slowed significantly in South Korea, the other nation that started lockdowns more than a week ago. We cannot afford to wait to see if our current efforts will work, since it is spreading too fast and the current level of prevention has not worked elsewhere yet. For purposes of this article, I am assuming a full or major lockdown in the U.S. within two weeks. I do not see another course of action until a proven vaccine in sufficient quantity is available. That is my base case. If we continue with the partial lockdown and many business closures, the pandemic will likely last longer with probable worse economic consequences.
Impact of a Lockdown Scenario
Based on what China has done, and the time the virus is in human bodies, a 30-45 day lockdown will probably be needed. The alternative is partial lockdowns and many business closures over a longer period. The following is a list what that will mean for banks.
1. Much less new lending – Lending is the lifeblood of banks. If more loans are paid off than made, loan balances decline. Loan balances will decline due to much less demand and banks’ own tighter lending standards. That leads to less interest income. For most banks, interest income is their largest source of revenues. The good news is many loans are for 5 years or longer, so they pay off relatively slowly.
2. Credit lines will be drawn out – A lockdown means most businesses doors will be closed or limited for 30-45 days. But they have expenses that don’t go away, like wages, rent, insurance, commitments and the like. The average small business does not keep that much cash around. That is also true to a slightly lesser degree for larger businesses. Most profitable businesses have a line of credit for daily operations and other temporary financing. A large number will be living off that line until business starts back up.
3. Lower interest rates – Rates have been slashed. All loan interest rates based on the prime rate, or LIBOR, will immediately drop 1.50% lower. That’s the bad news. The good news is deposit rates are also dropping, though more slowly. They also have less they can drop than 1.50%. The other good news is all those 5-year fixed-rate term loans stay where they are. The net effect should be a moderate to high compression of banks interest margin (interest income less interest cost). The amount will change from bank to bank. Those with more fixed-rate loans will fare better.
4. More bad loans – There are numerous businesses that cannot handle a 30-45 shutdown. Some may never reopen. The amount of uncollectible loans will increase significantly. How much again depends on how aggressive or conservative each bank’s lending standards are. There are crosswinds here. One major trend in commercial lending is a significant reduction in loan covenants banks use to protect themselves. This means they often have to wait until the borrower defaults before they can take action. That is offset somewhat by the fact that the banks around today all survived the last recession, which took out those that had poor lending practices. Bad loans are very expensive. They reduce interest income as payments stop. They increase legal fees and management costs.
5. More Real estate Owned – Loans that get foreclosed on result in the bank taking title to real estate. Not only does that real estate not pay interest, but the bank has to now pay real estate taxes, insurance, maintenance, management and repairs.
6. Wealth Management – The majority of banks over $1 billion in assets have a wealth management division that helps clients with their investment portfolios. The pricing is usually a percentage of the client’s portfolio. A big drop in stock prices results in a similar percentage drop in wealth management revenues.
Large Banks’ Additional Problems
In addition to the problems above, larger banks, especially Money Center banks, have other big risks.
As noted above, they lend to industries such as airlines, aerospace, oil & gas, mortgage REITs, and leveraged hedge funds, which the smaller banks usually don’t touch.
They have many derivatives on their books used to help customers hedge interest rates, currencies, and commodities. If hedged properly, that is usually not a problem. The risk now is counter-party risk. What if the company they are hedging with goes under?
Some larger banks have overseas exposure where economies may be even weaker.
Most credit cards in the U.S. are issued by the largest banks. Scale is imperative in this business. A large increase in unemployment will lead to many more charge-offs.
Large banks have less residential loans as a percentage of assets than smaller banks. Residential loans tend to be safer. People tend to stop paying other loans before defaulting on their residential loans. The last recession was an exception, but only because residential lending standards got way too loose. That is not the case this time.
Below is a table showing the stock price movement of a sample of banks. They are the first 20 Community banks, 8 Regional banks and 5 Money Center banks listed alphabetically in Value Line. The S&P 500 peaked on February 19th. Current prices (as of March 18th) are compared to that date.
(1) Performance in the last recession rated from 1 (worst) to 5 (best).
(Source: Value Line, FDIC, Yahoo Finance and SEC)
As shown above, all bank stocks have dropped considerably, about 40% on average. Money Center and Regional Banks have dropped slightly more if you exclude the Bank of Hawaii outlier. Bank stocks are now mostly trading below book value. This means the stock market expects large losses, as they usually trade above book value. In the next section, I will go over the factors that cause some to trade weaker than others. But looking above, you can see that banks that performed poorly in the last recession are on average down more with a lower price-to-book than the others.
How Banks Will Fare in This Environment
The first question is how long the Covid-19 crisis will last. The first fallback is that viruses usually go away come April. That is still possible, but the recent spread in warmer weather areas makes that questionable. The second fallback is the current partial lockdowns and business closures. We won’t know how effective they are for another week or so. They will likely slow things but not stop it. The third fallback is a full or major nationwide lockdown for 30-45 days. That is my base case. The Chinese showed that does work, though it is painful. But a short, sharp pain is much less damaging economically than a less intense but drawn-out one.
Let’s start by drawing one major conclusion: we are in a recession. It’s just a matter of how fast we recover. Using the base case, here is what can be expected.
First of all, banks have an advantage over most businesses in this environment, as they don’t have to be open for most of their revenues to keep coming. Interest keeps getting accrued until the borrower demonstrates it can no longer pay.
The type of loans that will suffer most will be different this time. Usually, the hardest hit in a recession are non-owner occupied commercial real estate loans, especially land, development and construction loans. Those loans were the primary reason we lost thousands of banks in the 1980-1982 and 2007-2009 recessions. In 2007-2009, residential mortgages were also hard hit, primarily subprime loans. However, only the Money Center banks had a lot of subprime mortgages. The loan type at most risk this time is commercial loans, including owner-occupied real estate loans. Those are followed by consumer loans for credit cards and vehicles, and then the usual suspect, non-owner occupied commercial real estate.
Regarding commercial loans, as I mentioned earlier, many, if not most, businesses will be either closed or at much reduced revenues for the next 1-3 months at a minimum. They will have to rely on their balance sheet and lines of credit. There are several things businesses can do in the short term. After cash runs out, they can stretch their payables. They can draw on their lines. They can stop all new purchases of things like inventory and fixed assets. They can lay off employees to save on labor expense. They can stop drawing an owner’s salary. They can temporarily stop paying rent and taxes. They can sell or borrow against fixed assets. However, eventually, many will run out of ways to conserve cash and will stop paying on their loans. The Federal government and some more local governments will likely help some. There is already talk of loans or other aid to essential industries, such as airlines, aerospace and hotels.
Regarding consumer loans, many individuals who have lost their jobs have little in savings. They will continue to pay on their residential mortgages as long as they can, and will stop paying credit card and vehicle loans first. The unemployment rate will be totally dependent on how long businesses stay shut or reduced. I have seen estimates as high as 20% if this drags out.
Another item of concern to some is bank liquidity. Let me emphasize this: bank liquidity is not a problem. Banks these days have overwhelming sources of places they can go to for liquidity. The biggest sources are borrowing against their loans and investment securities with reverse repurchase agreements and Federal Home Loan Bank Advances. Another source is the Fed. The Fed has already opened up its lending window wide open to banks.
In the last recession, the Federal government invested directly into banks in what was heavily derided as a bailout. Several hundred billion dollars were directly infused into the healthier banks as preferred stock. This program was, in my opinion, the most successful government program in the last two decades. It stabilized the banking system, it was not dilutive, and it actually made money for the government. This is a definite possibility to repeat if necessary.
Another issue is the interest rate yield curve. The bigger the curve (long-term rates higher than short-term), the better. The yield curve has widened significantly in recent days, as shown below.
So, it will come down to two things. One, how long the virus lasts. Two, how risky each individual bank is. Let’s look at the latter next.
What to Look for in Individual Banks
While Community and Regional Banks share many of the same characteristics, there are many differences which will dictate how they trade in a recessionary environment. These are summarized below.
1. Level of risky assets – How much of their portfolio is commercial, owner-occupied commercial real estate and consumer? Commercial non-owner real estate becomes more of an issue the longer the virus drags on.
2. Track record – The stocks of banks in the list above, such as Citigroup (C), Atlantic Capital Bancshares (ACBI) and Ally Financial (ALLY) are getting hit harder, in large part due to their weak performance in the last recession.
3. Concentrations – Banks that have a large amount of loans to a riskier industry such as oil and gas, restaurants and hotels should have more bad loans.
4. Current level of delinquencies – We have had a strong economic expansion for years, and most banks have few bad loans. Those that have a higher-than-average level indicate they are likely to be harder hit due to looser underwriting standards.
5. Geography – Banks in places like Texas, Oklahoma, Louisiana and the Dakotas will suffer if oil and gas prices stay down a while, even if they have no direct loans to companies in that industry. The local economies will suffer more than other places. In the list above, Business First (BFST) of Louisiana and BancFirst (BANF) of Oklahoma are two of the stocks down most. Also, if we have lockdowns in only certain areas, those areas will likely have more bad loans.
6. Capital level – Most banks have a significantly higher level of capital to assets than they did going into the last recession. This gives them a bigger cushion to absorb losses. An average level for Community and Regional banks is around 10% capital to assets. Be careful with those significantly below that, though there are relatively few.
The following two charts show what the market thinks about current credit quality. They show the yield investors want for junk and investment grade bonds. Banks loans are mixed through both categories.
I expect most banks to suffer, but to perform better in this recession than the last one for the following reasons, assuming the recession is relatively short-lived.
1. They have significantly more capital.
2. Many of the looser lenders were weeded out by last recession
3. There are no major bubbles to pop like the dot.com in 2000 and subprime mortgage in 2007.
If the virus pushes us into a longer recession, I still think they perform better, as long as businesses reopen and the recession after the virus is gone isn’t too sharp.
Community and Regional banks have less risks than the largest banks, but also tend to have looser underwriting or many higher-risk small businesses that have less liquidity. I recommend avoiding the largest banks for now.
As always, some banks will perform poorly due to loose underwriting. If you see a bank’s problem loans balloon rapidly in excess of peers, look to sell.
I currently have no position in any bank stocks. However, I feel it is likely that the 40% average drop in bank stocks is excessive. That view will change if the pandemic stays longer or results in a major recession after its gone. I would consider buying a few bank stocks or an ETF or basket of banks once we get a better picture on the containment of the Covid-19 virus.
The chairman of the Federal Deposit Insurance Corp. on Thursday urged an accounting rule maker to make delays or exceptions to certain accounting rules to help financial institutions tackle the fallout from the coronavirus pandemic.
In a letter, FDIC Chairman Jelena McWilliams requested the Financial Accounting Standards Board, which sets U.S. accounting standards, to give large public lenders the option to defer implementing a new rule on expected future credit losses. The companies that decide to delay implementation would revert to the old model of recognizing losses once they had evidence the losses had been incurred.
The rule, known as Current Expected Credit Losses, or CECL, requires companies to forecast expected loan-related losses as soon as a loan is issued. It went into effect for large U.S. public companies in December. The FDIC approved a measure in 2018 allowing banks to take three years to phase in the impact of the rule on their regulatory capital.
The economic uncertainty of the pandemic may cause banks to face higher-than-anticipated increases in credit-loss allowances at a time when they should be focused on lending to businesses and consumers, Ms. McWilliams said.
The regulator also sought a delay for certain lenders that were expected to adopt the rule after December 2022. Financial institutions are better off focusing on ensuring the safety of their staff, customers and local communities, Ms. McWilliams wrote.
Market volatility related to the pandemic is expected to make the implementation of CECL challenging for companies because of the difficulty in making predictions about credit risk, especially if they rely on economic indicators for forecasting.
Ms. McWilliams also asked FASB not to classify coronavirus-related loan modifications as a concession creditors can grant during troubled-debt restructurings. Companies want to avoid that classification on their financial reports, Ms. McWilliams said. Allowing companies to skip categorizing modifications as TDRs would encourage them to offer forbearance to customers facing economic stress during the coronavirus pandemic, she said.
In response to the letter, a FASB spokeswoman said the organization agrees with the need for close coordination with the Securities and Exchange Commission and banking regulators to address issues associated with loan modifications. “We’re also continuing to work with financial institutions to understand their specific challenges in implementing the CECL standard,” she said.
Lawmakers in the U.S. Senate and the House of Representatives introduced several bills last year in an effort to delay the credit-loss standard and study its potential effects. Those bills haven’t advanced beyond referrals to committees. Sen. Kevin Cramer (R., N.D.) on Wednesday introduced the latest bill, this time proposing the implementation of CECL be delayed until December 2024 for community banks.