July 17, 2023 | On Friday we described some of the bigger takeaways from bank earnings for Premium Service subscribers, but one huge headline goes against the narrative of rising rates helping bank earnings. In fact, the rate of increase in both deposit costs and loan yields is slowing compared with 2022. The FDIC reported in Q1 2023:
“The average yield on loans increased 32 basis points from the prior quarter to 6.08 percent. The increase in average loan yields represents a sizable deceleration over the 73 and 65 basis-point increases reported in fourth and third quarters of 2022, respectively. Average loan yields increased for all QBP asset size groups relative to the previous quarter.”
The popular narrative in the Big Media says that banks are benefiting from higher interest rates. In fact we all dodged a bullet in Q2 2023 because the repricing of assets and deposits slowed from the crazy levels seen at the end of March. Big h/t to Fed Chairman Jay Powell and other regulators for providing ample liquidity to get everybody to calm down.
The mark-to-market problem remains, however. The mark-to-market losses facing banks still tally into the hundreds of billions of dollars. But at least we are making money on deposit fees. In this regard, a reader named Joan of long acquaintance writes about the latest producer price data:
"The .01% PPI headline was totally dependent on the +0.2% contribution it got from Services. In turn, Services was supported by something called “Deposit Services” which posted +5.4% m/m. So of course, I had to look that up. As you can see, the jump in the cost of 'Deposit Services' happened in March which coincides with the bank failures. What gives?"
Our take on the numbers is that a LOT of institutional money moved around in Q2, part of the reason that fees rose 11% at JPMorgan (JPM). The House of Morgan did add 1.75% to its gross loan yield in Q1 2023, yet the increase in Q2 was half that amount looking at the GAAP disclosure. Overall, the rate of improvement in deposit rates and loan yields for the industry as a whole is slowing markedly. The folks on the FOMC need ponder whether this changes after one or two more fed funds target hikes.
The other big eye opener we’ve seen with several banks is that lending fell in Q2 2023 as bank treasurers more than tapped the brakes on new lending in order to let portfolio runoff naturally build cash. Banks receive payoffs and prepayments every day or some 20% of the balance sheet annually on average, so if you take your foot off the gas in terms of new loans and renewals, cash accumulates quick.
The fact that Wells Fargo (WFC), for instance, is exiting correspondent lending, will cause the bank to generate a lot of cash. But WFC is not typical for the industry. Consider the example of Washington Federal, Inc. (WAFB) in Seattle, a $22 billion asset bank we rated when we worked at Kroll Bond Ratings.
WAFD has grown assets 10% in the past year and has seen steady deposit growth through the first two quarters of 2023. WAFD is a strong performer within Peer Group 1 and typifies the type of super community banks above the key $20 billion asset regulatory threshold that have caused Peer Group 1 to grow to 140 institutions over the past year.
WAFD is known for having steady profitability and a strong credit culture, with most of the bank’s loans secured with real estate. Yet the bank deliberately throttled back lending in Q2 to less than $1 billion compared with $2.7 billion in Q1 2023, a stark indication of how even strong banks such as WAFD reacted to the sudden failure of Silicon Valley Bank.
Commercial loans represented 63% of all loan originations during the second quarter and consumer loans accounted for the remaining 37%. “After nine consecutive years of net recoveries, during the last two quarters we have experienced net loan charge-offs. It is clear the rapid rise in interest rates is causing some stress for a limited sub-set of borrowers, but taken in its entirety, credit quality remains a positive differentiator for the Bank,” WAFD told shareholders.
WAFD notes that commercial loans are preferable as they generally have floating interest rates and shorter durations. “Over 85% of our loans are secured by real estate with an estimated average current loan to value ratio under 45%. While there will likely be further stress for certain segments, we believe the Bank's conservative underwriting will accrue to our long-term benefit.”
WAFD reported an efficiency ratio of 52% in Q2 2023, below the average for Peer Group 1 and just behind the hyper-efficient JPM at a stunning 48% overhead ratio in the second quarter. One of the things that we like about WAFD is that their overhead costs are significantly below Peer -- 65bp below their peers in fact. The bank is in the bottom 20% of Peer Group 1 in terms of overhead costs vs average assets and in good company with the likes of Bank OZK (OZK).
Like many banks, WAFD has doubled cash on hand over the past six months and has also seen a steady migration of deposits into time deposits and out of uninsured transaction accounts. And over the past six months, WAFD has increased deposits and also added $1.5 billion in additional debt liquidity to support growth. The table below is from the Q2 2023 earnings release from WAFD.
So what does WAFD tell us about banks during the rest of 2023? Holding more cash with less market exposure is the wave of the future, which with T-bills over 5% is fine for now. In fact, WAFD had positive accumulated other comprehensive income (AOCI) over the past couple of years!
You see, not all banks are dumb. The positive AOCI at WAFD, a key measure of overall balance sheet duration, fell 70% in Q2 vs Q1 of 2023, but at least the number was still positive. Big h/t to CEO Brent Beardall and his team. This means that the management of WAFD, who are primarily real estate lenders, has more than a clue about market risk and duration. JPM, by comparison, had a negative $14.6 billion mark in terms of AOCI at the end of Q2 2023.
This $22 billion super community bank only has 6% of assets in long-duration securities. Sabe? The average securities holdings of large US banks is 16% of total assets which is really too high. Anything over double digits makes us want to walk the treasury team out of the building. When you are in a secular interest rate tightening, there is no reason for a bank to be long duration and especially long MBS or whole mortgage loans. Selling loans and investing treasury proceeds in swaps and mortgage servicing assets is the proper strategy.
If US regulators want to get a handle on the risks that caused three major bank failures in 2023, then the answer comes down to characterizing bank business models. How does the bank fund and deploy its assets? If the answer is like Silicon Valley Bank, where we put more than 40% of assets in MBS, then it’s time to call in the FDIC and maybe bring the FBI along for good measure. Call us severe, but bankers who deliberately run an insured depository into the ground are imprudent and deserve prosecution. This is about more than simply clawing back personal compensation. Have a good week.
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