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Update: U.S. Bank vs. Bank OZK; Q3 2022 Earnings Setup

October 12, 2022 | On the eve of bank earnings for Q3 2022, we take a look at one of the best performing banks in the US, both in terms of financial results and the performance of the stock. Readers of The Institutional Risk Analyst know that we have long admired Bank OZK (OZK) and its management for delivering consistent earnings and managing commercial credit on a national basis.



How will this above-peer performer from Little Rock do in a Fed-induced recession that rivals 2008 in terms of market losses? We also provide our latest thoughts on Q3 earnings as the large banks guide down due to the collapse of Wall Street trading and new issue volumes, but Main Street lenders are positioned to benefit. Lower for longer on funding costs as loan coupons and securities yields rise is a recipe for upside surprises from lenders from U.S. Bancorp (USB) on down in asset size.


When we talk about a recession that usually means credit losses a la 2008. But this time it’s different. In 2022, many banks are also fighting a rising tide of market losses on loans and securities created during QE in 2020-21. Indeed, we hear that there are literally dozens of community banks that will lose access to the Federal Home Loan Banks this quarter because mark-to-market (M2M) losses have rendered them book insolvent.


In a reprise of the S&L crisis, solvency not book capital is what matters at the FHLBs. For the same reasons, the Federal Reserve System is insolvent to the tune of about $1 trillion or roughly 15% of its SOMA securities portfolio. We all know that “other comprehensive income” or OCI consists of revenues, expenses, gains, and losses that a firm recognizes but which are excluded from net income.


How long can auditors and investors ignore accumulating OCI, especially in a rising interest rate environment? End of Q4. Think "impairment" and about the totality of M2M losses in banks and nonbanks in Q3 2022, losses that will increase as the year goes on and into 2023.


OCI only works if the value goes up and down. As we noted in National Mortgage News, the M2M on billions in defaulted loans bought out at a premium from Ginnie Mae MBS pools is just as nasty as the mark on those Ginnie Mae 1.5s in the SOMA portfolio. Think about the little depositories that went to sleep during 2021 and neglected to sell or hedge that toxic low coupon paper guaranteed by Uncle Sam. Fortunately, neither of our subjects today made that mistake.


So let’s compare OZK and USB and see what the numbers tell us. OZK is a $26 billion total asset lender focused on the national commercial real estate market. OZK is an AR state-chartered, unitary bank with no parent holding company, meaning that the FDIC and state regulators are the primary supervisors. While there is no Fed performance report on NIC, the uniform bank performance report produced by FFIEC has many of the same metrics we use below.


Half of the balance sheet is commercial real estate loans secured by the asset, but more than half of the balance sheet is core deposits. OZK has a loss rate close to zero, almost 14% Tier 1 capital leverage, and an efficiency ratio that is twenty points (20 pts) below U.S. Bancorp, the most efficient of the large bank lenders.


We start by comparing the operating efficiency of USB, OZK and Peer Group 1. Notice that OZK has an efficiency ratio almost half that of the larger banks and USB, which again is the most efficient of the top five banks. OZK shares this hyper-efficiency with NexBank Capital, which we profiled earlier this year.

Source: FFIEC


The superior operating efficiency of OZK is typical for smaller banks, which averaged 54% for Peer Group 2 and almost 60% for Peer Group 1 in Q2 2022. But the secret to OZK’s consistent above-peer performance is not only a story of operating efficiency. The pricing on the bank’s loan book is also excellent and consistently above its smaller and large peers as shown in the chart below.


Source: FFIEC


Even before COVID, OZK was pricing its loans more than a point better than USB and significantly above Peer Groups 1 & 2. One reason for this stellar performance is that OZK basically avoids 1-4 family loans (< 10% of total loans), meaning that the bank was able to dodge the worst effects of QE. Yet even on 1-4s, founder George Gleason and his team manage to price loans above the 90th percentile of both Peer Groups 1 & 2. Price discipline is the bottom line with OZK, which means loan yields at least 200bp above the top four money centers. Note in the chart below that OZK is not far from Citigroup (C) and its subprime consumer book.


Source: FFIEC


Even when other banks were seeing returns crushed by QE, OZK maintained its focus on commercial lending and thereby increased its pricing for loans. Yet in addition to gaining better pricing on its loan portfolio, OZK has managed to keep losses low or even negative, as was typical for many better managed banks during QE.


Notice during 2020-21 that OZK managed to push realized losses down even more than USB and Peer Group 1. But here is the big question about OZK, USB and all large banks: Will the volatility seen in global markets now also push credit costs back up to pre-COVID levels or higher? Our answer to that question is yes. Thus investors need to focus on banks with a history of effective credit management as winter comes to lending after a decade of QE.


Source: FFIEC


The answer to the question of credit in Q3 2022 and beyond is essentially answered by our previous comment (“Will the Fed Pivot or Pause?“), where we contrast the idea of a “pivot” with a pause. We think that as reserves run out of the system and, more important, the FOMC sets a new effective floor under interest rates, credit costs will revert to the ST mean and then go higher. Remember, the FOMC has done QE for almost 12 years and has suppressed credit costs during that whole period. As shown in the chart below, loss given default (LGD) is now negative (-35%) for bank owned real estate loans. The 50-year average LGD for bank-owned real estate loans is 71%.

Source: FDIC/WGA LLC


The net result of superior efficiency and asset pricing at Bank OZK is more revenue finding its way down to the bottom line. But one important piece of the puzzle to consider is funding costs, as shown in the chart below. OZK does not have a big advantage over the larger banks in terms of funding. Indeed, as the chart illustrates, the funding costs of the banks large and small basically have converged, but this process is about to be reversed.


Source: FFIEC


The summation of all of the factors we have discussed above is net income vs average assets, one of the more important performance measures for a bank. The rate of return on assets for USB, OZK and Peer Group 1 is shown below.


Source: FFIEC


Q3 2022 Earnings


Since we put out our quarterly look at the top banks ("Large Banks: QT Winners & Losers"), the larger banks have continued to guide down down in terms of investment banking and capital markets. We continue to expect improving loan growth and NIM, but the benefits of cheaper funding will not be felt universally by the larger banks.


Citi and Goldman Sachs (GS), for example, will continue to see increases in funding costs, as will all nonbanks raising funding from market facing sources. These banks are simply not competitive with JPMorgan (JPM) or Wells Fargo (WFC).


Of note, WFC contacted us this week and said that they are not exiting mortgage warehouse lending as part of a larger pullback from residential mortgages. History buffs will recall when WFC exited residential lending once before in the early 1990s, before the "acquisition" by Norwest. But the ghost of Norwest has now left the building at Wells Fargo HQ.


We think it is notable that WFC has slowly crawled back to #6 among our bank surveillance group, now down just 15% YTD vs more than 30% declines for JPM and Bank of America (BAC). We also think that USB, Truist Financial (TRU) and PNC Financial (PNC) may benefit more from rising yields than the top-four money centers. Our colleague Dick Bove thinks BB&T may have finally emerged from the long and painful merger process with SunTrust. We'd sure like to have Truist back in the game, especially with that half trillion asset category getting crowded.


Bottom line: Earnings growth numbers for the major banks are generally negative due to the expected collapse of new equity and debt underwriting activity. Trading results may be highly variable among banks, but this is hardly reason for joy since hedging market volatility is nigh impossible at present. Ask a lender, any lender, about loan pricing today.


JPM, for example, is estimated to see earnings fall 30% for the year. We expect similar results for GS, Morgan Stanley (MS) and other investment focused banks. Asset gathers such as Charles Schwab (SCHW) and Raymond James (RJF) should suffer modestly from falling assets under management, but will benefit from funding costs. At the end of Q2 2022, SCHW's cost of funds was just 8bp vs total assets compared with 26bp for JPM. And Charles Schwab is now the 7th largest bank in the US.


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