The IRA Bank Book Q2 2021: Lower Earnings Ahead

June 3, 2021 | As the second quarter of 2021 winds to a close, the banking industry saw strong GAAP earnings, buoyed by the reversal of over $14 billion in loan loss reserves back into income in Q1 2021. This money was earned last year, however, and masks the relative weakness of core bank earnings outside of highly variable business lines such as investment banking. After putting aside $60 billion in reserves in Q2 2020, the industry is now releasing these funds back into income, an accounting rather than a cash event, as illustrated in the chart below.

Source: FDIC

The actual swing in loan loss provisions is larger than $14 billion, since in “normal” periods the industry puts aside $10-15 billion in new reserves each quarter. If we adjust the stated pre-tax income for Q1 2021 by say down a modest $20 billion, the earnings of the industry fell sequentially in the first quarter of the year.

You won’t hear that negative comment from the major financial media, however, because investment managers are committed to owning the banks at near-record valuations. Notice in the chart below that the best performer over the past six months has been Western Alliance (NYSE:WAL), which just happens to be among the best performing large banks in Peer Group 1.

Even as public market valuations for US banks soar to levels well-above a year ago and bond spreads likewise have contracted to 2007 levels, the return on earning assets for the banking industry fell to a 50-year low in Q1 2021. We anticipate that bank asset returns will continue to drop so long as the FOMC persists with quantitative easing, as illustrated by the chart below.

Source: FDIC/WGA LLC

It is interesting to note that the Fed has already begun to taper its purchases of agency mortgage-backed securities (MBS) because of falling issuance in the housing finance sector. Meanwhile, lending spreads are continuing to tighten in most markets, following the example of corporate bond spreads. As the Federal Deposit Insurance Corp noted in the Quarterly Banking Profile:

The good news in Q1 2021 was that the amortization of mortgage servicing assets slowed and the results for trading and investment banking were up double digits. Servicing fees also rebounded into positive territory after several quarters in the negative. We expect that the investment banking results will likely revert to the mean in Q2 2021, while servicing income and amortization of servicing assets should contribute positively to bank financial results as loan prepayments continue to slow. The components of bank revenue are shown below.

Source: FDIC

A big source of positive lift in Q1 2021 results came from the reduction in non-interest expense across the board, a trend we expect to see maintained in Q2 2021. As the FDIC notes:

The good news in terms of non-interest income, however, was offset by some continued weakness in lending volumes and the overall leverage on the balance sheet, which fell to just 47% of total assets deployed in loans. While our colleague Joe Adler notes in a recent post that new lending volumes continue to be strong, prepayments also remain brisk across all asset types. Readers should remember that large banks tend to be more buyers of loans than originators of these assets, an important distinction that is often missed by Wall Street.

To give our readers a sense of just how skewed by Fed actions are the financial results of US banks, the chart below shows the growth rate for net operating income going back five years. While the Fed managed to engineer a huge increase in bank income in Q1 2021, including an increase in net interest margin and the release of loss reserves, the industry is still $40 billion or some 22% below the Q3 2019 peak of $180.8 billion for gross interest income. That is, bank interest income is shrinking due to QE.

Source: FDIC

In other words, the reduction in the cost of funds for banks is largely responsible for the increase in net interest income, but income from earning assets is likewise falling towards zero. The decline in NIM illustrates this trend. But the change in net operating income also shows a basic truth about the past five years, namely that income growth rates have been muted and at times dreadful. This experience mirrors that of independent mortgage banks (IMBs) over the same period (2018-2019), when primary-secondary spreads were very tight and lending profits suffered.

Source: FDIC

If we back out the conservative $20 billion in loss provisions from the Q1 2021 results, the actual return on equity (ROE) for the industry in Q1 2021 was closer to 12% and the return on assets (ROA) would be more like 1%. Indeed, this is the run-rate baseline we believe that analysts and investors should use for the industry going forward, not the GAAP results shown in the chart below. Once the release in loan loss provisions is complete, the industry’s income on a going forward basis should fall to this level.

Source: FDIC

The Bottom Line

As the charts above suggest, we expect NIM for the banking sector to continue to fall as the earnings on bank assets reflect the relentless downward pressure of current FOMC policy. The release of reserves earned in 2020 will mask this alarming trend for the next couple of quarters, yet the basic direction of bank fundamentals in terms of asset returns and net-interest income is flat to down.

We expect the return on earning assets to touch 50bp before the FOMC relents and changes policy later this year. This suggests that NIM for the industry as a whole could fall below 2% by December, a diminished level of income that puts the entire US financial system and especially larger banks at risk. For example, the return on total earning assets for JPMorgan Chase (NYSE:JPM) was just above 2% at year-end 2020 vs 3.52% for Peer Group 1.

Banks profit from the spread between funding and the return on assets, but while cheap funding helps earnings in the near term, eventually asset returns fall to the same level. This is the situation facing the US banking industry today. Unless and until the FOMC changes policy and ends its massive social experiment via QE, an experiment that is clearly deflationary, we expect bank earnings to come under growing downward pressure.

Credit Charts

From a big picture perspective, the credit profiles of most US banks improved in Q1 2021 as net charge-offs to loans fell below 40bp for the first time in many years (Q3 of 2006). Much of the improvement in the average data for all loan types is due to the impact of QE on housing sector exposures, which continue to exhibit extraordinary metrics in terms of net-loss and also loss given default (LGD). COVID and other factors are also flowing through different loan categories, as discussed below.

Notice in the first two charts for the $10.8 trillion in total loans and leases that realized losses as well as LGD have fallen sharply since Q2 2020. It is reasonable to ask what happens to this picture as and when the FOMC moderates monetary policy and QE.

Total Loans & Leases

Source: FDIC

Source: FDIC/WGA LLC

Moving to the biggest sub-category on bank balance sheets, namely total real estate loans, there is also clearly a downward impact on LGD for the $5 trillion in real estate loans owned by banks. Net-charge off rates basically are zero and non-current loans have begun to flatten out with the end of the COVID lockdowns.

Notice the huge downward skew in LGD after several quarters of large net-charge offs in 2020. Again, it is reasonable to ask what will happen to this portfolio as and when the FOMC changes policy. Our view is that LGD for all real estate loans will start to normalize toward the 67% LT average loss rate as more urban commercial real estate (CRE) is restructured to adjust for lower operating income.

Total Real Estate Loans

Source: FDIC

Source: FDIC/WGA LLC

Construction & Development Loans

Like the real estate category, the small portfolio of bank construction and development (C&D) loans evidences a significant skew in terms of LGD, but far less than loans for 1-4s and HELOCs. Last quarter LGD for the $380 billion in C&D loans was 41% and non-current loans stood at 0.72%.

Source: FDIC

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Source: FDIC/WGA LLC

1-4 Family Residential Loans

While the data for real estate loans appears normal at the top-level portfolio, the series for residential mortgages is extremely skewed and evidences the radical social engineering from the FOMC.

Rising home prices have pushed down the cost of credit default in the $2.4 trillion in 1-4s owned by banks to -73% in Q1 2021. This means that when a rare event of default actually occurs, the bank forecloses on the property, pays off the loan and then takes a profit! The LT average LGD for 1-4 family mortgage loans is 67%. Notice that non-current rates for 1-4s, after rising immediately after the start of COVID lockdowns, has flattened out and is slowly declining.

Source: FDIC

Source: FDIC/WGA LLC

Home Equity Loans

The bank portfolio of home equity loans or “HELOCs” continues to shrink, with the total unpaid principal balance (UPB) now below $300 billion. The skew in loss rates for HELOCs is as extreme as it is with 1-4s with net charge-offs and LGD both in negative territory. Of note, non-current rates on HELOCs are rising and are still mostly in normal territory compared with first lien 1-4s.

Source: FDIC

Source: FDIC/WGA LLC

Rebooked Ginnie Mae Loans (EBOs)

Another important perspective on the world of 1-4 family loans comes from the data series published by the FDIC on rebooked Ginnie Mae loans, known in the industry as “early buyouts” or “EBOs.” These are delinquent loans that have been repurchased by the Ginnie Mae MBS issuer and have thus been “rebooked.”

Source: FDIC

In Q3 and Q4 of 2020, issuers such as Wells Fargo (NYSE:WFC), Penny Mac Financial Services (NYSE:PFSI) and New Residential (NYSE:NRZ) were aggressively buying EBOs in the hope that these loans could be cured and sold into a new MBS pool, generating a substantial gain-on-sale event for the issuer. Instead, many of these delinquent loans may linger for months as the servicer tries to resolve the loan, generating substantial cash losses for the issuer.

Multifamily Loans

As with 1-4s and HELOCs, bank loans backed by multifamily properties have shown a significant downward skew in terms of credit costs, but less so than other residential assets. The $480 billion in bank-owned multifamily loans saw LGDs reach into negative territory in 2019 and 2020, however the series has now reversed back into positive loss values, suggesting that some assets have been adversely effected by COVID and are starting to generate losses to banks. The net charge-off rate remains near zero, but non-current loans are rising and LGD was 67% in Q1 2021, above the LT average for this key metric.

Source: FDIC

Source: FDIC/WGA LLC

Commercial & Industrial Loans

After total real estate loans, C&I credits at $2.5 trillion in UPB are among the most important assets on bank balance sheets. Roughly half of these "commercial" loans are related to commercial real estate loans. LGD for C&I loans has been falling since last year due to the effect of the FOMC’s radical policy prescription, but we suspect that the series will turn and start to rise as 2021 progresses and the restructuring of commercial assets accelerates. It is important to note that despite the positive impact of low interest rates on credit loss, LGD for commercial bank exposures is still above the LT average of 57%.

Source: FDIC

Source: FDIC/WGA LLC

Credit Card Loans

While the data for credit card loans is relatively normal compared to loans in the real estate complex, the results for Q1 2021 do show some impact from QE and ultra-low interest rates. Card balances continue to fall, however, after peaking near $1 trillion in UPB at the end of 2019. Of note, bank credit card loans totaled just $760 billion as of the end of Q1 2021, but loans to individuals continued to rise at $928 billion.

Source: FDIC

Unsecured consumer loans are some of the highest yielding assets that a bank can hold, thus watching credit cards and other unsecured credits provides important insights regarding future bank earnings. We suspect that card balances will stabilize in coming quarters, but the one imponderable is whether proceeds from home sales will be used to pay down consumer loan balances.

Source: FDIC/WGA LLC

Auto Loans

Bank-owned auto loans stood at $500 billion at the end of Q1 2021, but the credit metrics for this largely prime asset class are anything but normal. Realized losses on auto loans peaked above 70% of the loan value in 2016 and has declined ever since.

Source: FDIC

When COVID exploded onto the scene in April of 2021, the impact on the auto sector was to reduce the supply of new vehicles and increase the value of used cars. The result in terms of bank credit was a sharp drop in realized losses on defaulted auto loans. LGD on delinquent auto loans fell to just 35% at the end of 2020. Look for this metric to revert to the LT mean as 2021 progresses.

Source: FDIC/WGA LLC

As COVID recedes and the auto industry eventually addresses the shortage of semiconductors that has limited the supply of new cars, we expect that the LGD will return to the LT average of ~ 55% of the face amount of the loan. Notice that non-current auto loans were trending higher since 2018, but fell in Q1 2021. The net-charge off rate has remained muted due to the strong market for used cars, a situation that may persist through 2022.

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