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October 12, 2021 | In this Premium Service edition of The Institutional Risk Analyst, we set the table for third quarter earnings reports for the top US banks. For banks and other financials, credit costs remain muted or event negative, lending volumes are likely to remain flat and credit spreads remain under intense downward pressure despite rising market interest rates. Bank lending volumes are essentially going sideways as nonbanks lenders continue to take share across most major asset classes.
First and foremost, we must start the discussion by reminding our readers that Western Alliance Bancorp (WAL), which we wrote about favorably earlier in the year, has out-performed every large bank in the US YTD. The WAL purchase of AmeriHome from Athene (ATH) is a great example of how well-run regional institutions can great big value for investors.
WAL may not have the low funding costs of the top six money center banks, but it is able to compete because of superior management and focus on balance sheet efficiency. The table below shows the funding costs for the top six US commercial banks and Peer Group 1.
Notice that PNC Financial (PNC) at just 12bp has the lowest cost of funds in the group, even compared with U.S. Bancorp (USB) and Bank of America (BAC). Like most banks, PNC has negative growth estimates going forward into 2022, but the Buy Side manager community continues to own this name and other large cap banks on the expectation of a future, positive earnings story. The Street consensus has PNC delivering 7% revenue growth with 20% earnings decline in 2022.
Next we look at the gross spread on average loans and leases, an important measure for bank profitability. The only large bank that is even close to the average spread for Peer Group One is JPMorgan Chase (JPM). Smaller banks tend to have better loan pricing power than larger banks. As a result, the unweighted average spread for the 131 banks in Peer Group 1 was over 4% but BAC was just 3.2%, one reason why the Bank of Brian performs so badly on the net income line.
We exclude Citigroup (C) in this comparison because the bank’s subprime consumer book makes it more comparable to tiny CapitalOne (COF) than to its asset peers. Even though C is regularly grouped along with the other money center banks in terms of assets, it has a very different business model and funding base. Notice, however, that C has seen 200bp of compression in its gross loan spread since the end of 2019.
The Street has C doing almost $5 in earnings for the full year, then doubling in 2022 to just shy of $10 on less than 2% revenue growth. The stock is trading at 0.8x book value on a 1.8 beta. So, you get the Citi stock a discount but almost 2x average volatility vs the S&P 500. What a deal.
Next let’s look at net loss vs average assets, a key measure of future credit losses. As the chart suggests, the reported losses of major US banks continue to fall, this due to soaring asset prices. Charles Kindleberger, the MIT economic historian, described a bubble as an “upward price movement over an extended range that then implodes.” In other words, a bubble can be identified only after it has burst.
For banks and credit, the issue for the future is to understand how much has the FOMC’s aggressive monetary policy impacted credit spreads and asset prices. Since many of the better financials that we track have become sellers of assets rather than buyers in the past several months, we think it is important for investors and risk professionals to take note. Today’s benign credit environment is likely to have some surprises for investors in loans and related servicing assets tomorrow.
Two sectors that bear watching at multifamily mortgage loans and urban office buildings, two traditionally solid asset classes that are being adversely impacted by the federal and state forbearance programs. Unlike residential loans that are largely curing themselves thanks to low interest rates and soaring home prices, urban multifamily assets and office properties are showing signs of stress. We expect these impaired asset classes such as urban office properties and multifamily housing to be a source of credit losses to banks in 2022.
As the change in work patterns that resulted from COVID are confirmed be the attrition among tenants of urban office buildings, we expect asset prices to fall and conversions to begin occurring, a process that may take years to unfold. In a future interview in The IRA, the CEO of one of the nation’s largest lenders talks about how they are releasing office space around the country because the facilities have no prospect of being utilized. There is a huge corporate migration away from urban office space that has yet to be recognized by investors and policy makers.
Below is the chart for net income and a percent of average assets, the summation of the first three charts that show funding costs, loan spreads and net credit loss rates. Note that USB, JPM and PNC are consistently leading the pack, then Peer Group 1, then BAC and Wells Fargo (WFC) following with below peer asset returns.
Citi is competitive with other large banks due to its higher gross spread, but still manages to deliver a mediocre net income performance because of high funding costs and SG&A. The table below shows efficiency ratios for the group and Peer Group 1. Note again that BAC and WFC have elevated efficiency ratios vs the group, where JPM leads the pack with a ratio in the mid-50s. But look at the strong progress that Citi has made under new CEO Jane Fraser, dropping its efficiency ratio almost ten points over the last year.
Another key metric to watch after the basic financial performance metrics is stock buybacks, even before dividends the single largest means of capital return to investors. Some banks such as JPM have resumed stock purchase at near pre-COVID levels, but others have not such as WFC and BAC. Given the weak outlook for earnings going forward, we do not expect banks to return to 2019 levels of stock buybacks anytime soon.
Notice that JPM is still running below peak levels of share buybacks from 2020 and 2019. The Street has JPM delivering over $13 in earnings in 2021, but dropping to $11.85 in 2023. We agree that tight spreads and a dearth of attractive assets will continue to weigh on large banks. The disruption of the Asian market in terms of investment banking opportunities is another theme that we believe should be monitored carefully.
Bottom line for US banks in Q3 2021 is that earnings and revenue growth are muted due to the environment created by the FOMC. Bank lending is lagging the huge levels of deposit growth seen over the past 18 months due to quantitative easing. The rise in interest rates seen at the end of the quarter has not provided relief to banks in terms of spreads, the most important component of bank net interest income. Until that changes, we do not expect to see expansion of bank earnings except from cost cutting and improved operating leverage. Our bank surveillance list is shown below.
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