Taking It To them Bank(s)
by Brian Pretti CFA, Contrary Investor. May 11, 2007
We all know these days that unlike prior cycles, there has been so much debt securitization in the broader financial system that the commercial banks are no longer the primary focal point of total credit risk when credit cycles turn dark, as has very much been the case in the past. In fact, this new age phenomenon of broad securitization and dispersion of credit risk throughout the system has been held up as the economic and financial market holy grail in the current period as to why boom and bust cycles are conceptually a thing of the past, or at best muted in effect. Of course I love the characterization made by many a talking head that this new age securitization and dispersion has "created wealth." For whom, the packagers and sellers of paper? You better believe it has. Too bad this didn't work for New Century, right? So what about the banks? You know that THE big sector in the S&P is the financials. Totally fitting for an economy dominated by a credit cycle. And in this, the banks are a key subsector.
Cutting right to the bottom line, the specific reason this is important right now is that there has been more than noticeable deterioration in broader commercial banking conditions over the last few quarters, not that the consensus seems to be looking. In the spirit of honesty, integrity and not trying to sound melodramatic, we need to keep in mind that deterioration in loan quality and performance is now ticking up from what have been either historically low levels, or levels quite close to all time lows. But conceptually, much like the almost overnight drying up of funding to the sub prime industry, the recent deterioration in bank loan quality seems to have come out of nowhere in a very short period of time. Moreover, if you believe that as an economy we have lived through the credit cycle of a lifetime whereby more and more ongoing credit availability has simply masked inherent credit problems or simply put those problems off for another day, so to speak, then watching for signs of change in credit quality deterioration becomes extremely important as an ongoing exercise. Let's get one thing straight -- the banks as businesses are about to fall off of the proverbial cliff; it’s just that we need to anticipate a worsening of asset quality conditions to come. It's already started. Conditions that may indeed influence management behavior, as has absolutely been the case in past credit cycles, and ultimately change the shape of the current credit cycle. Especially important is the thought that the recent events in the land of sub prime are anything but a one off and self contained experience. Remember, although no one really knows what lies ahead, this is EXACTLY how credit contractions start.
Some quick facts. In 4Q of 2006, which is the most recent period covered by the FDIC quarterly bank report, the total loan delinquency rate for all US commercial banks saw its largest quarterly increase in six years. For total loans, delinquency levels are back to where they stood in 2004. As you'd guess, heavily driving total loan delinquency rates in the banking system is what you see below - delinquency in residential real estate loans. For now, the move off of the bottom has been, shall we say, abrupt and sharp. The only other abrupt and sharp experience of this magnitude was seen directly prior to the 2001 recession.
In conjunction with the fact that delinquent loans are ticking up is the slowing in overall loan demand. In 4Q of 2006, total loans and leases in the banking system grew by what is the smallest quarterly increase in half a decade. Residential mortgage loan demand saw its smallest increase in three years. And real estate construction loan growth experienced its smallest advance in two years. You get the picture and can see the dynamics. Loan growth slowing and problem loans rising. Quite the set of circumstances for the commercial banks. But this is just part of the total story. Before moving forward, the companion chart to the one above is the commercial bank charge-off ratio for residential real estate loans you can see below. Not the end of the world at all, at least not yet.
But here's where it starts to get interesting and here's where fuel is added to the fire of the headwinds facing the commercial banking community at the present. As of the end of 4Q, the US banking system clocked in with its lowest loan loss reserve ratio in twenty-two years. The chart below chronicles the history of the loan loss reserve ratio and actual loan losses as a percentage of average total loans for the banks. The absence of meaningful loss experience over the recent past few years has enabled bankers to keep reserves quite low, clearly enhancing earnings. But the data above suggest the tide is changing. IF forward loss experience deteriorates, bank loan loss reserves will become a problem and will need to increase by default, necessarily cutting into reported earnings. In fact, in 4Q, the banks did indeed increase loss reserves, just not at a level commensurate with actual loan loss growth; hence this ratio fell even further as bank asset quality deteriorated. If the banks themselves do not act to reconcile these trends if indeed they persist, the regulators will force them to do so.
And again, all of what you see is occurring within the confines of a US banking system record. As of 4Q 2006 period end, the net interest margin for US commercial banks stood at a record low. Below is simply the history of the current decade to date, but you can trust me, this is an all time low as of YE 2006. You know why. The inverted yield curve of the moment is killing profit growth at the banks who do not engage in proprietary trading or investment banking, which is the bulk of commercial banks in this country.
We expect that by this point, the picture is becoming crystal clear for you in terms of the headwinds the US commercial banks are facing at the moment. Rising loan delinquencies and charge-off's, crimped profitability in terms of the tightest interest margin on record, and a loan loss reserve position as weak as anything we've seen in over two decades. Talk about taking it to the banks, this confluence of circumstances is far from the happy talk we hear on the Street. Of course the important issue looking ahead is degree or magnitude of loan deterioration to come in addition to interest margin, or interest rate spread, compression. As you'd guess, this is exactly the type of circumstances we'd expect to see in a change of character for a prior credit cycle of incredible magnitude. THAT's the important issue. Accommodative and proactive Fed / Treasury / Administration/ Big Wall Street banks or not, from a short term standpoint the commercial banks need to accelerate lending and diffuse or cut short loan losses to keep the bigger credit cycle game going. And this means only one thing in terms of the old college try - monetary inflation. Seems to always come back to that, now doesn't it?
What is also clear going through these numbers is that there is a huge difference between the large behemoth so-called commercial banks in this country and everyone else (the regional and community banks). The big boys, of course, can rely ever more heavily in the current environment on proprietary trading (levered financial speculation), investment banking, derivatives trading, etc. And this means that they are implicitly relying on stable to upward movement in financial markets to which they are applying ever-increasing amounts of leverage in their "trading" activities. As you know, at least as of late, this is exactly what has been delivered to their collective doorsteps.
But for the bulk of commercial banks in the US, collecting deposits and making loans is their business, not trading interest rate swaps and various CDO trenches. It's the regional and smaller players that are indeed hurt the most in terms of declining interest rate spreads and deteriorating asset quality (loan quality). So, in essence, much of what is the current character of the environment of new age finance (structured products, excess monetary liquidity globally impacting yield curve characteristics, super tight lending spreads aided and abetted by derivatives overlays, proprietary trading importance, etc.) has really acted to hurt the bulk of the mainstream US banking industry via lack of participation relative to their behemoth bank brethren. Question. Do these smaller and regional banks really matter anymore, or is it just JPM, BAC, C and a handful of other mastodons that will drive the US into the financial future that lies before us?
One what I believe is very important perspective. It's the character of total banking industry loans outstanding at the current time. No big mystery. Of course the obvious issue being that the banks are simply loaded with real estate exposure right here. Loaded. Real estate exposure is over three times their exposure to C&I (commercial and industrial) loans and almost five times larger than exposure to mainline consumer loans. As an incredibly simplistic comment, this is why those suggesting we simply dismiss the deterioration in sub prime, Alt-A credit markets, etc. are nothing short of foolhardy. US commercial banks are wildly exposed to the asset that has been levered most heavily in the current decade and the one whose nominal price is most exposed to at least some magnitude of credit contraction. And you can bet your last dollar this is completely understood by the Fed. There is no way the Fed is going to watch real estate conditions deteriorate meaningfully without taking perhaps drastic action. Will the Fed allow the dollar to go to hell in a hand basket before standing back and watching mortgage credit markets, as well as the collateral behind them, suffer in any meaningful pain for any extended period of time? Monetary inflation, the cure all, all the time? Yes...until it's not, of course.
One final chart that may indeed be the most important of all. Quite simply it's the year over year rate of change in bank real estate lending. So here's the deal. Imagine this were a stock price chart. The wedge formation here is as clear as a bell. Since the early 1990's, the year over year rate of change in bank real estate lending has put in a very well defined series of higher lows. But since early in the current decade, it has also put in a more than well defined series of lower highs. Eventually there will be a break out, if you will, in this formation. Let's face it, this has been the longest upward cyclical rise in real estate related bank lending anywhere in history dating back to 1950. Does this cycle really end right here and up we go to all new levels of bank real estate lending? C'mon. It sure seems a better bet that ultimate reconciliation plays out to the downside. Much like the housing starts and permits cycles of the past, historical bottoms have been COMPLETELY consistent across the last four decades in this experience of bank lending. Like real estate pricing cycles, lending cycles too have been characterized as boom and bust. And so in this cycle it should be different? Only if we are about to rewrite history. This chart tells us that the year over year change in bank related real estate lending bottoms near 5% or below. Given the "extension" in the current cycle, we would not be surprised at all to see a negative number at the eventual cycle bottom.
In short, there you have it. Banks face numerous headwinds at the moment. Loan quality is deteriorating, profit spreads (net interest margin) are compressing like never before, loan loss reserves as a percentage of loans outstanding stand at multi-decade lows (very little cushion to any rising loan problems), and banks in aggregate today are more exposed to real estate than any time in history. The world is not about to come to an immediate end, but banking system fundamentals are quite the challenge. Again, very important because the financial sector is very important to the overall equity market as a leadership group in a credit based economy.
It's a fact that since the current equity rally began in 2003, the BKX (Philly Bank Index) has bottomed either coincident with or prior to important interim bottoms in the S&P. In the following chart I have marked these periods. It just so happens that tops (that are not marked) have also been leading or coincident. Notice also the very big divergence with BKX price and corresponding weekly RSI and MACD indicators since early 2006. Is this a warning or is momentum (RSI and MACD really) about to spike upward? We'll see. To be honest, this divergence period really corresponds with the beginning of the slowdown in real estate as an asset class. Is this telling us something?
Final chart to keep an eye upon is the XLF - the ETF for the S&P financial sector. Admittedly, more broad in character than just the banks found in the Philly Banking Index. Look at the long-term trend line dating back to early 2003. If this is broken to the downside, it will suggest raising the caution flags for both the economy and financial markets a few notches. Volume needs to accelerate here to the upside as the longer term on balance volume indicator has recently modestly broken a key trend line. Lastly, just look at the actual volume explosion in the recent decline in the XLF itself. Nothing like it dating all the way back to 2003 at least.
In short, the banks and financials more broadly are KEY to the equity markets and the greater economy as a whole, especially an economy running on something other than a traditional business cycle. Remember, credit contractions always begin at the margin. In the current environment, what may truly be different is speed. By that I mean speed of reconciliation when credit deterioration begins. If the almost overnight implosion of New Century is to be a model or a foreshadowing in concept of what's to come, the public credit markets will react swiftly to heightened risk. Will the banks also? Because at least for now, deterioration in loan quality at the margin is clearly in evidence. But given the lack of response in upping loan loss reserves in 4Q of last year (clearly in deference to maintaining reported earnings), bank managements seem a bit more complacent than are, say the former providers of funding to the likes of the New Century's of the world. We'll just have to see who has been quickest off the draw as this very special credit cycle continues to play out before our eyes. The banks should be a key tell.
© 2007 Brian Pretti