A Bull Case for US Banks?

December 13, 2021 | In this Premium Service issue of The IRA Bank Book Q4 2021, we ask whether bank fundamentals are starting to catch up to the very full equity market valuations, up some 40% since the end of 2020. And as a special Christmas thank you, this issue of The Institutional Risk Analyst is free for all of our readers through year-end 2021. As the year ends, income is up and credit defaults are down, at least for now and at least in single family housing assets. Yet there are storm clouds on the horizon for US banks in terms of commercial and consumer loan exposures as COVID loan forbearance ends on January 1, 2022.

The IRA Bank Book Q4 2021

The social engineers on the FOMC have created a monster bubble in non-agency residential assets. Piggyback loans have reappeared and the level of fraud in loan manufacturing volumes is rising, classic late-stage indicators. The world of fix and flip loans is looking positively rancid, with levels of missed first payments soaring, raising questions about hidden risk on bank warehouse lines. Roughly one in three FHA residential mortgages that were modified during the past 18 months of COVID forbearance are headed for re-default.

Bank owned multifamily credits continue to show unusually high loss severities. It could just be 2007 all over again, but the difference is that the problems arise from multifamily and commercial assets instead of 1-4s as in 2008. Enjoy the higher interest rates while they last. Once the true cost of credit starts to emerge in 2022, the plunge protection team may need to put pedal to the metal again. Bank equity market valuations, not surprisingly, have been going sideways since mid-year.

Source: Google

Review & Outlook

The third quarter of 2021 saw some expansion in terms of nominal yield and also spreads for all US banks, pushing up the return on earning assets (ROEA) for the first time in almost a year. A big driver was $5 billion in negative provision expense in the quarter or a $19 billion total decline in credit provisions vs 2020. The return on average assets actually slipped a few basis points compared with Q2 2021, causing net income to decline, the FDIC reports. The chart below shows the long-term return on earning assets for US banks.

Source: FDIC/WGA LLC

Another big factor in the surge in Q3 2021 earnings was the falling cost of funds, just $8 billion in Q3 for the entire banking industry. The chart below shows the components of net interest margin through Q3 2021. Notice that interest income fell $45 billion from 2019 through 2020 due to the wasting effects of QE.

Source: FDIC/WGA LLC

Nearly three-quarters of US banks reported higher net interest income compared with a year ago, a promising sign. Banks saw higher non-interest income as servicing fees, investment banking and interchange fees all increased in Q3 2021 vs the same period in 2020.

The allowance for loan and lease losses (ALLL) as a percentage of total loans and leases declined 55 basis points to 1.69% from the year-ago quarter due to negative provisions, the FDIC reports, but ALLL remains higher than the level of 1.18 percent reported in fourth quarter 2019.

The chart below shows pretax income vs provisions, one of the most important income statement relationships in banking, back to 2007. Provisions may remain at or near zero for some time given the current sufficiency of the ALLL, a positive for earnings so long as credit expenses remain muted due to QE.

Source: FDIC/WGA LLC

With provisions expense likely to remain low for some time, the outlook for earnings should be positive – but we have a long way to go to reach some level of normality vs the pre-2018 bank earnings. Dividends are back up and above pre-2019 liquidity crunch levels, but bank income – if you subtract the impact of negative provisions – is still struggling.

The FOMC would need to let interest rates rise by at least 100bp in order for banks to reach normal levels of income measured by asset and equity returns. As things stand today, we expect earnings for US banks to stabilize at 2018 levels and extraordinary GAAP adjustments to income end as 2022 progresses.

Source: FDIC/WGA LLC

The big area of expansion in bank balance sheet continues to be securities, while loan balances are just barely growing. The runoff of Paycheck Protection Program (PPP) loans is another source of portfolio deflation in Q3 2021 that is likely to become more pronounced in Q4. Commercial (C&I) loans were down $301.8 billion, or 11.9 percent in Q3 2021. The decline in C&I balances was driven by PPP loan forgiveness and repayments, and loan sales.

Relative to the growth in deposits, the increase in loans in Q3 2021 was trivial, continuing a trend that goes back several years. Indeed, deposit growth surged even as lending essentially stalled. The FDIC reports:

With the end of QE, bank deposits should begin to run off, depending on whether the FOMC actually allows the portfolio to decline. The chart below shows the total deposits and loans for all FDIC insured banks.

Source: FDIC

The bank migration out of the world of residential asset sales and servicing continues, with nonbank servicers now accounting for more than half of all 1-4 family assets. Assets serviced for others (ASFO) by banks was $2.9 trillion at the end of Q3 2021. Bank portfolio loans are more or less stable at $2.4 trillion, but HELOCS are rapidly disappearing at just $270 billion in unpaid principal balance. Nonbanks now service $6.6 trillion in 1-4s and, baring some act of insensitivity in Washington, will rise above $7 billion in short order.

Source: FDIC, FFIEC, MBA

At just $344 billion in Q3 2021, bank sales of 1-4 family mortgages are less than half of the level seen in Q3 2015. Of interest, after several quarters of no sales of C&I loans, banks sold $6.3 billion in commercial loans in Q3 2021. Sales of “other loans, leases, and other assets,” of note, also reached an all-time high of $99.5 billion, suggesting that banks are seeking to shed less attractive, “miscellaneous” exposures going into 2022.

Source: FFIEC

The value of MSRs owned by banks, which accounts for less than a third of the total servicing market today, rose over the past several quarters due to rising interest rates, secondary market demand and other factors. Notice that servicing fees are back in positive territory after spending 18 months at or below zero due to COVID and the progressive loan forbearance scheme in the CARES Act.

Source: FDIC

It is some indication of the absurdity of the CARES Act that almost all of the households that asked for or involuntarily ended up in forbearance have exited successfully. That said, look for the Consumer Financial Protection Bureau and other agencies to find faults of the most minor sort in handling CARES Act forbearance. As with the SEC under Joe Kennedy in the 1934-35, the CFPB’s agenda is entirely political. Other agencies such as the Office of the Comptroller of the Currency have likewise been taken over by progressive zealots, as we discussed in our comment on Cenlar FSB.

Sector Charts

Total Loans & Leases

Source: FDIC

Levels of default and delinquency continue to fall through Q3 2021, a trend we expect to see extend into 2022. Loan losses are at unusually low levels, however, suggesting that loss rates and provisions will normalize in the next year. As the chart below suggests, loss given default (LGD) has skewed lower during the period of QE since 2018. The average LGD on total loans since 2007 is 80%. As the Fed withdraws extraordinary open market intervention, these credit relationships will normalize.

Source: FDIC/WGA LLC

Total Real Estate Loans

The $5.1 trillion portfolio of real estate loans represents a quarter of bank assets. Delinquency and net charge offs remain muted compared with the long-term averages, largely due to loan forbearance and low interest rates for carrying and refinancing assets. The modest uptick in delinquency that occurred in 2020 and 2021 has now largely abated and the related reserves for loss, have also been released.

Source: FDIC

The chart below shows LGD for all bank owned real estate loans, yet another example of Fed social engineering. The series is once again in negative territory due to QE and the general market mania observed in private loan assets that has developed in the past 12 months.

Source: FDIC/WGA LLC

1-4 Family Loans

In the $2.4 trillion residential loan sector, the non-current rate is hoovering above 2% and the net default rate is also negative. The LGD for the sector is negative 132% vs the LT average of 60%, an illustration of the huge distortions caused by QE and other governmental actions. Once COVID loan forbearance ends and the Fed ends purchases of MBS, we expect mortgage rates to rise and home price appreciation to moderate.

Source: FDIC

Source: FDIC/WGA LLC

The table below shows residential mortgage delinquency rates by sector.

Source: MBA, FDIC

The big difference between December 2020 and this year, of course, is that we have not had significant foreclosures in the past 18 months, but 2022 will see a resumption of residential and commercial default resolutions and related regulatory action. In the final weeks of 2021, the mortgage industry received an unwelcome holiday gift from Consumer Financial Protection Board (CFPB) Director Rohit Chopra. The CFPB is preparing to announce multiple enforcement actions against several mortgage lenders for “deceptive practices” in dealing with COVID forbearance loans.

Home Equity Lines of Credit

As with 1-4 family mortgages, home equity lines of credit also show declining levels of delinquency and negative net charge offs. LGD for HELOCs was - 216% in Q3 2021, meaning that lenders are making 2x the loan balance upon default after paying off the loan.

Source: FDIC

Source: FDIC/WGA LLC

GNMA EBOs

Much like the other data series focused on residential mortgages, loans repurchased from Ginnie Mae pools are also showing moderating delinquency. The early buyout (EBO) trade has lost some of its luster, however, compared with a year ago when issuers were capturing record gain-on-sale margins on EBOs.

Source: FDIC

Inside Mortgage Finance reports that $11.14 billion of FHA/VA loans were repurchased from Ginnie MBS in Q3, the highest total of the year. The crowd of newbie investors investing in government servicing assets is astounding. Many investors, however, are learning that these trades are no longer profitable and, indeed, may actually generate a net loss when the loan is resolved. The resumption of foreclosures and the related increase in regulatory scrutiny of distressed loans will add to the cost of EBOs.

Multifamily Loans

Unlike the experience of most of the sectors of residential housing, the $492 billion in multifamily loans owned by banks are displaying high levels of loss upon default, a very bad sign for the future of many rental properties. The level of charge-offs is still quite low, but the level of delinquency is rising. More, the level of loss upon default is 75% in Q3 2021, above the long-term average LGD for multifamily credits of 60%.

Source: FDIC

Source: FDIC/WGA LLC

Commercial & Industrial Loans

The data series for most residential loans, excluding multifamily credits, generally show the impact of QE and monetary policy more generally in terms of subdued levels of default and delinquency. The $2.3 trillion in commercial and industrial loans owned by banks, however, display a more normal pattern of delinquency, albeit one that is still influenced by the skew in credit risk pricing that has occurred due to the radical policies of the FOMC.

In particular, the decline in both delinquency and defaults in C&I credits since 2019 is largely attributable to the Fed and also fiscal spending that is now past. As these funds dissipate, we expect levels of delinquency and default in commercial credits to return to normal levels. Indeed, despite the positive impact on default rates of monetary and fiscal policy, LGD for C&I loans was 60.2% in Q3 2021 and is still above the LT average of 56%.

Source: FDIC

Source: FDIC/WGA LLC

Credit Card Loans

One of the most profitable areas of bank lending is credit card loans, but as with other asset classes, this loan category has been shrinking rapidly. At the end of 2019, credit cards receivables owned by banks totaled $916 billion. At the end of Q3 2021, credit cards totaled just $800 billion, up from $776 billion in Q2 2021. In the age of QE, the Fed’s stated policy goal of causing an expansion of credit has failed. Instead, as rates have declined and trillions of dollars in fiscal giveaways have flowed from Washington into the economy, bank lending has barely shown any growth even as deposits have surged.

Source: FDIC

Likewise, LGD for credit card loans has fallen dramatically to just 63% at the end of Q3 2021 vs the LT average of 81%. Remember that these are unsecured consumer loans. Once the latest fiscal infusion has run its course, however, we look for delinquency and net-loss rates to return to the mean.

Source: FDIC/WGA LLC

Auto Loans

Like many other loan sectors, bank owned auto loans have benefited enormously from low interest rates and various federal and state forbearance programs related to COVID. The global shortage of semiconductors has also pushed up the secondary market price of used cars. Notice in the chart below that loan delinquency rates are still normal, but post-default loss rates actually touched just 30% in Q2 2021 vs the LT average loss rate over 50%.

Source: FDIC

With the start of 2022, however, most loan payment moratoria will end and the true cost of credit will surge back into view. COVID has also influenced loss given default for bank auto loans, as illustrated by the fact that LGDs for auto loans was actually negative in Q3 2021. The impact of disruptions in the supply chain due to COVID and the global shortage of semiconductors has made used cars more scarce, increasing prices for autos and necessarily pushing LGDs down as loan recovery rates have soared.

Source: FDIC/WGA LLC

The Bottom Line

We look for bank earnings to improve as interest rates rise, but the more crucial question of spreads on assets is likely to remain largely neutral. Unless and until we see a true increase in demand for credit, it is unlikely that banks will have any effective pricing power on assets. While the FOMC is going to end asset purchases by as early as March 2022, we do not expect to see any change by the FOMC in target interest rates for some time. Any return of equity market volatility a la 2019 or 2020, however, is likely to cause the Fed to retreat from its current worries about inflation.

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