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Forbearance, Shrinking NIM & Prepayments Menace US Financials

Updated: Apr 14

April 12, 2021 | In this issue of The Institutional Risk Analyst, we look at three key issues that you are unlikely to hear discussed in the financial media as banks and nonbanks begin to report Q1 2021 earnings this week:


  • Poor visibility on “expected” credit losses,

  • Ever shrinking net-interest margin, and

  • Massive loan prepayments in Q1 2021


Simply stated, US banks are twice as expensive as they were a year ago looking at earnings and assets, but have less transparency and greater volatility in terms of credit costs and income going forward.


Leading off earnings for the big boys on Tuesday, we’ve got one of our favorite specialty bank holding companies, Charles Schwab Corp (NYSE:SCHW). On Thursday we have another favorite we wrote about earlier (“Western Alliance + AmeriHome = Big Possibilities”), Western Alliance Bancorp (NYSE:WAL). Of note, that transaction closed in a matter of weeks, no surprise given the capital and operating strength of the bank.


After WAL, we’ll hear from JPMorgan (NYSE:JPM), Wells Fargo & Co (NYSE:WFC), First Republic Bank (NYSE:FRC) and Goldman Sachs (NYSE:GS).


JPM is at a five-year high, this after losing half of its value in the volatility downdraft of April 2020. JPM is up 170% since 2017, illustrating the fact that inflation is not low, even when it comes to relatively pedestrian bank stocks.


GS is up a mere 120% and WFC is down 13% over the same period. FRC is right behind JPM when it comes to equity market performance. The table below shows quarterly dividends declared by the top-five US BHCs.


Source: FFIEC


Of note, the Street consensus has JPM revenue down 4% in 2021, GS down almost 5% this year and WFC revenue down about the same amount as JPM. WAL, by comparison, is expected to turn in 44% revenue growth in 2021 and 2022 due to the acquisition of conventional mortgage aggregator AmeriHome from Athene (NYSE:ATH), a unit of Apollo Global Management (NYSE:APM).


The first key issue facing investors in US banks is visibility on credit. Former Fed Chairman Paul Volcker forced US banks to forbear on Latin debtors for a decade in the 1980s. At the same time, US regulators allowed zombie thrifts to continue to write business, a colossal mistake that cost taxpayers hundreds of billions in capital losses. But the great game of asset price inflation continued.


The forbearance that some lenders are providing today, often at the behest of federal regulators, is a cause for concern. How do we define “expected loss” when we pretend that dead assets are viable? We keep hearing suggestions of widespread forbearance in the commercial real estate channel, where asset values of many commercial buildings now are difficult to estimate. Net operating income is unknowable.


We noted in “The IRA Bank Book Q1 2021: Loss Reserve Releases to Boost Earnings,” that default rates across the board are too good to be true given the degree of dislocation in many sectors of the economy. As we watch banks releasing loan loss reserves this quarter, will they reveal the degree of credit forbearance being provided to large commercial borrowers? When good loans are hard to come by, banks make bad loans.


Just as in the 1980s with the S&Ls, the rules have been relaxed de facto in the name of avoiding a generalized debt deflation. Banks figure that it is better to support troubled developers now instead of foreclosing, a messy public process that tends to undermine that key ingredient in any leverage system, confidence. But what shall we do in three or six months? More loans after bad? We'll talk more about modern bank forbearance in a future conversation with our old friend Nom de Plumber.


When Fed Chairman Jerome Powell tells members of Congress that US banks are strong and well capitalized, does he mention widespread forbearance for delinquent commercial borrowers? No, Powell does not. Long-time Volcker friend and associate Richard Ravitch described the dire situation facing New York City last week in the Wall Street Journal:


“The city has over twice the national unemployment rate. Given the number of commercial and residential tenants who aren’t paying rent, the city will likely see a significant reduction of property-tax revenue, which accounts for more than one-third of municipal revenue. Hotels and restaurants are empty, the entertainment industry closed down. An enormous number of offices are empty because people have moved out of the city or are working from home.”


We figure that bank loss rates on commercial exposures in Q4 2020 understate by as much as half likely future losses. This is due to the impact of the CARES Act and state lending moratoria for consumers and unofficial forbearance for commercial obligors. But while we feel pretty good about the outlook for residential assets, not so with commercial exposures in major metros.


Q: Will the Fed and other regulators allow banks to milk loss reserves to boost income in Q1 2021 – even knowing that future losses on commercial exposures in major cities could be significant? A: Yes.


The operating assumption seemingly being followed by US prudential and housing regulators is that the economic recovery will heal all wounds when it comes to credit. We believe, however, that the benefit of Fed largesse is going to be uneven, just as the distributive effects of US monetary policy have been uneven going back half a century. We spoke about this with our friend Ed Kane (“Interview: Ed Kane on Inflation & Disruption”).


The second key issue you are unlikely to hear about from Buy Side pontificators this earnings cycle is the continued shrinkage of net-interest margin or NIM. Even as the FOMC has driven down the cost of funds for banks to record lows, the return on earning assets (ROEA) is falling just as fast, compressing bank margins and cash income.


Notice in the chart below that net interest income only rose in Q4 2020 because the cost of bank funding collapsed. Bank warehouse lines for agency loans are now quoted in fixed spreads ~ 1.50-1.75% without any mention of either LIBOR or SOFR.



Gross interested income was actually flat sequentially in Q4 2020, but interest expense fell to just $12 billion for the entire $21 trillion in assets held by the US banking industry. A decade ago in Q4 2010, the total assets of US banks were less than $14 trillion. But remember, inflation is still too low according to the FOMC.


Source: FDIC/WGA LLC


The fact is that cash to investors from banks in terms of dividends and share repurchases are running at about half of 2019 levels, part of the large environment of income annihilation that has guided the actions of the FOMC for more than a decade. The diminution of income to investors under quantitative easing has been massive and largely benefits the US Treasury.


The final factor in Q1 2021 bank earnings will be prepayments, both of residential and commercial loans. The accelerating runoff of assets under management (AUM) is a major factor contributing to the decline in bank interest earnings. As we noted in The IRA premium service over the past month, US banks have suffered huge capital losses in 2020 due to loan prepayments for portfolio and also assets serviced for others.


Assets totaling 20% of bank 1-4 family mortgages prepaid in 2020 and were mostly captured by nonbank lenders and the bond market, leaving banks and nonbanks alike scrambling to replace lost income. Giant end investors in mortgage servicing such as Lakeview and New Residential (NYSE:NRZ) have been decimated by annual prepayment rates in mid-double digits. Do you suppose that the folks on the FOMC have ever thought about the cost to investors of accelerated prepayments due to low interest rates?


With the rise in interest rates, conventional theory holds that bank lending margins should expand, but in fact the opposite is the case. Indeed, margins on both consumer and commercial loans are tightening as rates rise and volumes soften. Meanwhile, bids for whole loans and servicing assets are well-above fair value as growing numbers of investors enter the market in search of returns. Sound familiar?


The parallel between inflated prices for homes, loans and mortgage servicing assets is not a coincidence. Yet in residential 1-4s, secondary market spreads are once again so tight that more and more lenders are down cash after the close and even sale of the mortgage. This means they are dependent upon servicing fees to recoup net cash outlays to originate the loan. The year 2020 was one of those rare periods when lenders were actually up cash on lending for much of the year, a lot.


Both banks and nonbanks alike face a very painful year where prepayments on older, higher coupon loans will continue to generate losses, but the ability of banks and particularly REITs to replace these assets with new loan production is constrained. In essence, we have created the perfect storm for lenders of all descriptions, with political payment moratoria threatening to bankrupt some monoline owners of loan servicing later this year. If you pay 2x annual cash flow for an asset, which then prepays two months later, you lose money.


Bottom line is that financials are more expensive than ever measured by the ability of banks and nonbanks to pay dividends to investors. Visibility on future credit losses is poor and the rate of prepayments on consumer and commercial loans is making it even more difficult for financial firms to maintain equity returns in terms of dividends and share repurchases. Other than that, everything is great. Have a good week.



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