The IRA Bank Book Q1 2022 | Credit Risk Returns

March 7, 2022 | In this Premium Service issue of The IRA Bank Book for Q1 2022, we review the trends in the US banking sector as we head to the end of the first quarter of 2022. This report will be available to all of our readers through March 10th. The good news is that the skew in bank financial results caused by COVID and the response by the Federal Open Market Committee is nearly at an end. The bad news is that Russia's attack on Ukraine is creating new credit default events all over the world even as it pushes global prices higher. As the chart below illustrates, the contribution to bank earnings from negative loan loss provisions has just about run its course. In many ways, Q1 2022 is an inflection point for markets, inflation and risk.

Source: FDIC

As US interest rates have risen over the past several months, net interest income for all US banks has started to recover from the nuclear winter of quantitative easing or QE. While this is welcome news, the industry has a long way to go to return to the $180 billion in total interest income reported in Q1 2019. Meanwhile, domestic credit costs are building after a two year hiatus on loan payments c/o the Consumer Financial Protection Bureau and many states.

Source: FDIC

As NIM recovers from the lows of 2019-2020, asset and equity returns for the industry are actually falling. Assets and equity have continued to grow faster than bank income, a reflection of the strange dynamics at work in the banking sector as COVID quickly slips into memory. Part of the decline in the reported ROA and ROE stems from the end of the return of credit loss provisions back into income as shown in the first chart.

Source: FDIC/WGA LLC

The decline in public valuations for banks coincides with the drop in equity returns and a related drop in dividend income from banks. Cash dividends in Q4 2021 were almost $15 billion below the $54 billion in Q3 2021, as shown in the chart below. We continue to see evidence that the industry is headed back down toward 2019 levels of pretax income in 2022 even as credit costs again become an expense. Factor that into your thinking about future bank dividends and share repurchases.

Source: FDIC

Industry income, after all, dropped $20 billion in the past four quarters to just $77.6 billion in Q4 2021 vs a tad under $100 billion in Q1 2021. During the same period, public market valuations were bid up to near record levels. As we’ve noted in recent reports, several crypto banks such as Silvergate Capital (SI) soared to valuation multiples usually associated with the most speculative technology assets. Now that the industry has seen 25% of pretax income disappear into the black hole of QE, investment managers seem to have finally taken notice. Again, we are headed for a landing around Q1 2019 levels of pre-tax income for US banks in 2022, but operating expenses sadly are not affected by QE.

“Noninterest expense rose $7.8 billion (6.2 percent) year over year, led by an increase in “all other noninterest expense” and salary and benefit expense,” FDIC reports for Q4. “Higher marketing and data processing expenses drove the increase in the “all other noninterest expense” category. Average assets per employee increased from a year ago to $11.5 million.”

How have US banks managed to build reserves, pay earnings and repurchase stock even as interest income has fallen 25%? Because the Fed has stepped on funding costs with the full weight of the United States. “Average funding costs declined 2 basis points from the previous quarter to a new record low of 0.15 percent,” the FDIC reports in the latest Quarterly Banking Profile. One big reason to look for an expansion of bank earnings in coming months is the fact that funding costs will lag the rise of yields on earning assets. But that said, the starting point for the climb back in terms of bank earnings is Q1 2019.

Source: FDIC/WGA LLC

Last week Federal Reserve Chairman Jerome Powell suggested a three-year timeframe for reducing the Fed’s balance sheet. Brean Capital published a note saying that this would require some outright MBS sales in 2023 and 2024, Bloomberg reports.

Recall that as the Fed's portfolio shrinks, bank deposits are destroyed on a 1:1 basis with the reduction in reserves. As reserves shrink, banks will shift back into T-bills and Treasury coupons, and Ginnie Mae MBS, for reserve assets. Given these mechanics, we doubt that the Fed will be able to raise rate targets more than a couple of times without sparking a liquidity crisis.

While the rate paid on deposits is unlikely to move in the near-term, it is important to note that the relative slowing of QE has already started to evidence itself in a slowing of bank deposit growth. Once the Fed ends new investments and even starts to taper reinvestment of principal repayments, the rate of change for US bank deposits will slip into negative territory.

Source: FDIC/WGA LLC

But perhaps the most important news for the US banking industry in Q4 2021 was that bank loan portfolios finally started to grow after several years in negative territory. Most of these loans were acquired from correspondents or in bulk, not made by the reporting bank, but no matter, the numbers are headed north and may auger higher asset returns in future quarters. The key question is how fast the pricing for commercial loans will recover.

Source: FDIC

While the loan growth seen in bank portfolios is welcome, the big area of balance sheet expansion remains securities and particularly Treasury bonds. As the Fed seeks to shrink its balance sheet in coming months, and available reserves decline, banks will become ever more aggressive in terms of debt purchases. This also implies increased market risk on bank balance sheets, and hedging expenses, as risk free reserves are exchanged for Treasury coupons and bills.

“Growth in U.S. Treasury securities (up $175.7 billion, or 13.9 percent) continued to drive the quarterly increases in total securities,” the FDIC reports. “Loans and securities with maturities greater than three years now make up 39.4 percent of total assets, up from 36 percent in fourth quarter 2019.” Basically, banks are increasing long duration as interest rates rise, never a good combination. Look for hedge losses in Q1 2022 earnings for banks and nonbanks alike.

Credit Charts

Total Loans & Leases

The $11.2 trillion in total banks loans has started to grow, as shown in the chart above. Loss and recovery rates, which have long been distorted by QE and COVID loan payment moratoria, are starting to normalize. Loss given default (LGD) has rebounded from the 50-year record low of 56.7% and now seems likely to rise back into the 80s (the LT average is 79%, BTW). Indeed, we expect to see LGDs rise above the LT average as the economy sorts out the losses due to COVID and the Russia-Ukraine war. The latter factor is exogenous and will defy efforts to quantify, but most US banks have no direct offshore exposure.

Source: FDIC

Source: FDIC/WGA LLC

Total Real Estate Loans

The $5.2 trillion in real estate loans on the books of US banks, roughly a quarter of total assets, is perhaps the most heavily skewed asset class when it comes to bank loans and QE. The fact of low interest rates boosted residential and commercial asset values, pushing down loss given default to low and even negative levels. The loss rates on 1-4s, for example are deeply negative, suggesting that home lending has no risk.

The Fed effect is most pronounced in residential assets, where record low rates have driven growth in outstanding mortgage debt and a repricing of more than half of the stock of existing loans. But the repricing of residential mortgage assets since Q4 2021 has also created a lot of unrealized losses on the books of banks, REITs and funds that were caught asleep at the switch by the change in inflation expectations and price data, and thus Fed monetary policy.

Source: FDIC

Source: FDIC/WGA LLC

1-4 Family Residential Mortgages

With mortgage rates closing in on 4% vs below 3% a year ago, the dynamic in the market for quality residential loans and mortgage servicing rights has changed from originate to sell to buy and hold. Scores of regional banks, for example, have suddenly decided to get into lending on MSRs in the past several months. Sales of loans are falling fast as banks retain prime loans in portfolio.

The Fed is likely to end new purchases of agency and government MBS in March, suggesting that this collateral may see further erosion in prices and higher yields. The on-the-run Fannie Mae MBS, for example, is now a 3.5% coupon vs 2.5% a year ago, and probably headed to 4% in short order. By no coincidence, as volume and therefore liquidity ebbs in the secondary mortgage market, loans by banks to non-depository institutions rose $60 billion or almost 10% from Q3 2021.

Source: FDIC/WGA LLC

Note in the chart below that the post-default loss for bank-owned 1-4s rose from negative 130% in Q3 2021 to “only” minus 30% in Q4 2021. That means in those rare events of default in prime 1-4s, the bank sells the property, pays off the loan and pockets a profit. The magnitude of the skew in LGD for prime bank loans suggests to us that the upward price pressure caused by QE will continue for several more years. Note that the average LGD for 1-4s is still in the 50% range even though the Fed has brazenly manipulated home prices over the past decade.

Source: FDIC/WGA LLC

Home Equity Lines of Credit

Like first lien residential loans, HELOCs have experienced an enormous skew downward in loss rates, but also an increase in volatility. Banks actually reported an intriguing anomaly in Q4: negative recoveries (that is, a loss) and also significantly higher charge-offs in Q4 2021. This caused an enormous skew in the calculation for LGD that pushed the series back into positive territory after hitting negative 216% in Q3 2021. Sad to say, there are just $265 billion in bank owned HELOCs remaining and the book is running off at double digit rates despite rising interest rates.

Source: FDIC

Source: FDIC/WGA LLC

Rebooked GNMA Loans | EBOs

Another important indicator of the state of the loan market is early-buyouts or EBOs of delinquent government insured loans. In 2021, GNMA issuers were aggressively bidding for EBOs because of the potential to profit by fixing the loan and selling it into a new GNMA MBS pool at 105 or 106. Today, many of these loans are now priced closer to par, meaning that the issuer has less potential profit to work with in helping the borrower. As a result, the banks as a group are backing away from participating in the EBO trade directly, but they continue to finance this loss mitigation activity performed by nonbank issuers.

Source: FDIC

Multifamily Loans

The one real estate loan category that has bucked the trend in terms of the Fed’s positive impact on credit loss rates is multifamily loans. The $512 billion in bank owned multifamily loans showed positive loss rates and elevated levels of delinquency in 2021, a radically different picture than that for 1-4s and related credits such as construction loans. Indeed, it is a little scary to think what loss rates on bank multifamily loans would look like without the impact of the Fed's low interest rate regime and QE. The long-term average LGD was 59% through 2021, but the actual loss rate for bank multifamily loans was 10% above the LT average at 66.5%.

Source: FDIC/WGA LLC

Source: FDIC

Commercial & Industrial Loans

The $2.3 trillion commercial and industrial loan portfolio has also been skewed by QE and then the COVID loan payment moratoria in many states. Paycheck Protection Program loan forgiveness and repayment drove the 5.2% annual decline in C&I loan balances in Q4 2021. From January 1, 2022, however, most of the legal prohibitions on debt collection were lifted. Loss given default for the C&I book was still falling in Q4 2021 toward 50%, just below the LT average of 55% loss after default. We look for the LGD series and actual charge-offs or realized losses to rebound back toward more normal levels, a trend we expect to see shared by bonds.

Source: FDIC/WGA LLC

Source: FDIC

Credit Card Loans

Bank credit card balances reversed four quarters of decline and went back above $800 billion in Q4 2021. Consumer loans also grew strongly as ample reserves are finally turning into earning assets. Like other loan categories, bank credit card portfolios have seen a dramatic decline in reported levels of delinquency as COVID loan forbearance schemes have been in operation. With the end of loan forbearance, however, we expect to see credit card portfolios quickly return to 4% delinquency or higher. Notice that LGD for credit cards fell to nearly 60% vs the LT average loss rate post default of 80%.

Source: FDIC

Source: FDIC/WGA LLC

Auto Loans

Prices for used cars due to the disruption in the semiconductor industry, COVID and other factors have driven down loss rates on bank auto loans to zero in Q2 2021. The LGD on bank auto loans rebounded into the 30s this past quarter, but suffice to say that the next stop is probably higher. Most observers expect the tightness in supply for autos to be alleviated by 2023, thus we look for bank auto loan credit metrics to head back towards the LT average of ~ 60% loss given default.

Source: FDIC

Source: FDIC/WGA LLC

Outlook: The Return of Credit Risk

The outlook for US banks as the year began was for normalization of revenue, earnings and also credit metrics as the Fed began to reduce extraordinary measures for the economy. The end of forbearance schemes at the state and federal level means that the full cost of the credit dislocation of COVID will become apparent. Roughly one third of all government loans modified and re-pooled during COVID, for example, are likely to redefault in 2022.

We add a new dimension of risk to the normalization of US bank earnings with the Russian war against Ukraine. Whereas the cost of credit domestically is going to rise and assume relatively normal portion of bank earnings this year, the Russia attack on Ukraine has disrupted commercial and personal finances for tens of millions of companies and people around the globe. The primary and secondary effects of this destruction of value instigated by Vladimir Putin will be felt in credit losses to banks and commercial companies alike for years to come.

Going into the end of Q1 2022, we expect to see some lift to bank earnings from loan growth and a continued boost to net income in the form of reduced credit costs. Increases in gross loan yields will come later. It is important to state, however, that US banks go into an uncertain year with robust credit reserves. As the FDIC notes:

We expect to see banks make progress in terms of building back interest income that was suppressed by QE, yet investors and risk managers need to be mindful that Q1 2019 is the real benchmark. The noise and adjustments to GAAP earnings during 2020 and much of 2021 make these years a throw-away analytically. If the Fed sticks to its guns and raises the target for federal funds a couple of percentage points during 2022, then residential mortgage rates will be at 5% by 2024 and the great mortgage correction of 2025 will be well in sight. Add to that picture the price inflation of war in Europe and 2022 becomes a year of growing credit risk.

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