R. Christopher Whalen
Feb 97 min
February 9, 2024 | Premium Service | Is that sudden peak in consumer credit costs about to begin? In this issue of The Institutional Risk Analyst, we hear from Bill Moreland at BankRegData about the credit outlook for New York Community Bank (NYCB) and the banking industry more broadly. We then dive into the results from PayPal Holdings (PYPL).
Next week, we’ll take readers on a trip down memory lane and talk about why President Joe Biden needs to channel President Herbert Hoover of a century ago and resurrect the Reconstruction Finance Corporation to clean up the black hole of moribund urban commercial real estate.
As we noted the other day, NAREIT says the value of commercial real estate in the US was over $20 trillion in 2021. A lot of this supposed value was aspirational and assumed an inflating market. Today, we'd probably haircut the entire industry by 20% or $4 trillion. Maybe Barry Sternlicht's estimate of a $1 trillion loss is a little bit light? But hold that thought.
First the good news from Bill Moreland, the banking industry actually grew in Q4 after a year of shrinkage in assets and income. “The $258.60B Q4 increase is the largest in 8 quarters since the go-go printing days of 2020-2021,” he writes.
“The reason, as always, is the Federal Reserve: 1) About $90B of the asset increase was from AFS Securities valuation gains from Powell's conveniently timed beneficial December verbal pivot, and 2) Approximate $33B quarterly increase in the BTFP the majority of which was most likely a Cash arbitrage play.”
Moreland notes that cash deposits with the Fed held by JPMorgan Chase (JPM) and Wells Fargo (WFC) have soared. “Either the Fed is paying too high a rate and the largest banks would rather take the no risk 5.40% IORB, or the largest banks aren't comfortable lending in the current environment.”
We think that the latter is increasingly the case. Indeed, the Fed’s radical and really clumsy approach to managing reserves continues to offer banks a risk free alternative to private lending. How is this helpful? Bill Nelson at Bank Policy Institute wrote in his latest paper entitled “How the Fed Got So Huge”:
“Following the collapse of Lehman Brothers in September 2008, the Federal Reserve underwent a significant shift in how it implemented monetary policy, transitioning to an excessive-reserves framework that it had deemed too radical and rejected just months prior. This shift involved borrowing excessive reserves from banks, deviating from its traditional method of borrowing only the amount banks needed to meet reserve requirements and address clearing needs. Despite initial intentions to revert to the necessary-reserves framework, subsequent developments, including three rounds of quantitative easing, led to the permanent adoption of the excessive-reserves approach in January 2019 by the Federal Open Market Committee (FOMC). This decision was a mistake. The framework has not yielded the purported benefits, such as simpler policy implementation, and has required the Fed to be vastly larger than originally anticipated. Advocates of the excessive-reserves approach argue it aligns with the Friedman rule, but alternatives like a voluntary-reserve-requirement regime could achieve similar outcomes without the drawbacks.”
In terms of NYCB, the bank just elevated former Flagstar CEO Alessandro (Sandro) DiNello as Executive Chairman, but he and his team have a lot of work to do. Selling participations in credit exposures or outright asset sales is the first task. Moreland notes that charge-offs have been increasing across the bank’s portfolios. He reports on the latest CALL data from FDIC:
“Flagstar (NYCB) is not just a 'couple' of loans charging off, but rather increasing 30-89 Days Past Due (up $61.16 Million), NPLs (up $240.68 Million) and Performing TDR (up $122.46 Million). An argument can be made that even with the large Provision in Q4 NYCB is still under-reserved.”
We think that most bank portfolios are under-reserved because of the strange movement in loss provisions and, more, the volatility of loss statistics. As we note below regarding PYPL, the firm was reducing loss provisions in Q4. Moreland notes that non-performing loans, performing troubled debt restructurings and charge-offs on multifamily loans are growing at NYCB and across the industry. He writes in a note to clients:
“A number of other large Multifamily lenders are also having delinquency issues including Citibank, Merchants Bancorp, First Interstate, Citizens Bank and Peapack-Gladstone. We're also seeing Multifamily lenders restructure large chunks of their portfolio. Huntington has $144.62 Million of Multifamily TDR (4.58% of portfolio), First-Citizens is at $109.86 Million (3.48%) and M&T has $125.59 Million (2.05%).”
Notice the part about restructuring multifamily? That is going to continue for years to come. Many properties will see lender concessions to borrowers (aka a loan "modification"), hurting bank net interest margins. The alternative is for the bank to foreclose on a property that they cannot sell and do not want to own.
One issue Moreland notes that has been troubling us for a while is the impact of the Fed’s manipulation of credit markets and COVID loan forbearance on consumer credit scores and future credit loss rates. Two years of loan forbearance ℅ progressive politicians made subprime consumers seem to be prime and enticed banks to lend to these same faux prime consumers, who are now likely to revert to pre-COVID subprime behavior patterns.
“I see the fundamentals crumbling, but the market just sees rate cuts,” Moreland writes. “Sadly, the Fed's never ending war on savers has led us to raising a whole generation who believe that 0% interest rates makes things 'affordable'. As if the whole economy has become a used car dealership pushing 'low' financing.”
To those members of the financial media who keep telling us that the credit problems are in the smaller banks, we respectfully disagree. How about Bank of America (BAC)? Moreland notes:
“BAC reported a delinquency rate of 5.32% on Non Owner CRE when we really should be tracking their Delq+Performing TDR rate which jumped to 8.09% of their portfolio. Yes, a full 8% of Bank of America's Non Owner CRE portfolio is either delinquent or had their payments lowered.”
Meanwhile in Washington, Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen continue to predict the failure of banks and nonbanks, almost as though they want to get ahead of an inevitable meltdown. Yellen continued to prattle about the potential risk from failing nonbank mortgage lenders in her Senate Banking Committee testimony, this as commercial banks sink under the weight of accumulating credit losses.
Somebody should remind Secretary Yellen that liquidity was last year’s problem. This year and, indeed, the next five years is going to be about credit risk, as we’ve been predicting for some time. We think that banks and the whole industry could be driven into multiple periods of loss as they divert income to loss provisions. This is the risk that deserves, nay, demands the attention of Yellen and Powell.
Nonbank mortgage firms don’t retain a lot of credit risk on their books and tend to be net negative in terms of duration. As we noted in our last note, large forward issuers like PennyMac (PFSI) and Mr. Cooper (COOP) are actually paying off debt and deleveraging, and outperform most bank stocks even in a rising rate environment. Most mortgage issuers are shrinking their balance sheets and preparing for the rate cut cycle to begin.
Where we do see risk of systemic contagion is the reverse mortgage space, where several issuers of home equity conversion mortgages or HECMs are struggling to stay afloat. The Treasury had to seize the bankrupt Reverse Mortgage Investment Trust at the end of 2022. We think Janet Yellen may need to size at least one more Ginnie Mae HECM portfolio before very long, at a cost of billions more losses to the taxpayer.
PayPay Holdings
Like many financials that we follow, PYPL had decent Q4 2023 earnings, but is getting no love from the equity markets. Margins were flat and only expanded because of expense control. Membership and active account metrics were basically flat. The market has shown little interest in PYPL as a result. The stock price fell after the earnings release.
Source: Google Finance
Payment volumes are growing in the mid-teens internationally and about 10% in the US, again hardly a poor performance. Transaction expenses are growing 17% in the latest quarter, however, focusing the future on whether PYPL can grow faster and scale expenses lower at the same time.
Source: PYPL
Credit expenses are very low, two digits to the right of the decimal point. Again to the point above about loss provisions, PYPL was taking credit reserves back into income in Q4 2023 because actual losses were so low. Of note, PYPL took a $1.6 billion hit on the sale of buy-now-pay-later (BNPL) receivables originated as held for sale and subsequently sold. PYPL had taken gains on this paper in previous quarters. It may be that the market for consumer IOUs is weakening.
CEO James Chriss noted that "In Q4, we delivered 9% revenue growth on $410 billion in total payment volume. Transaction margin dollar performance was better than expected in the fourth quarter, and we continued strong expense discipline, reducing non-transaction-related expenses by 9% year-over-year." In other words, transaction costs are rising faster than revenue, so we cut operating expenses -- aka people -- by 9 percent.
Bottom line is that PYPL has lost its lustre as a fintech stock and, compared to some of its comps such as Affirm Holdings (AFRM), is really getting no love from the equity markets. Non-GAAP earnings per share were $1.48 in the quarter, representing 19% year-over-year growth. Higher earnings per share in the quarter were driven by ongoing expense reductions. While some of our colleagues continue to publish aspirational comments about PYPL, we see more stable and boring financial performance ahead.
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