The guest commentary below was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
This week we posted the Q3 2019 edition of The IRA Bank Book, our quarterly review of the US banking industry. And to celebrate and say thank you to our readers, we’ve put the new edition on sale for 40% off the regular list price of $99 through close of business this Friday, September 13, 2019.
In this issue of The Institutional Risk Analyst, we take a modest victory lap for our 2017 call predicting that net interest income (NII) for the US banking industry would peak and decline early in 2019. After feasting for years on the "extraordinary" policy of the Federal Open Market Committee (aka "Financial Repression)," the banks are now getting squeezed in a deflationary vice. We write:
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“In 2008, total quarterly funding costs for US banks was over $100 billion. We expect to see total funding costs for the industry close to $60 billion per quarter by Q1 2020, suggesting considerable additional pressure on bank profit margins in terms of the gross yield spread over funding costs. That said, we think it very unlikely that bank funding costs will return to the $80-100 billion per quarter run rate that prevailed pre-2008.” |
Ponder the fact that the US banking system has grown 30% since 2008, but the cost of funds for the industry is still less than half of pre-2008 levels. The great bailout of the US banking system by the Fed continues, but most analysts, media and policy mavens are too credulous to state the obvious. Just look at the data. Funding costs are rising, but yields are falling.
In addition, we review the small but influential universal banks operating in the US. There are a number of non-US banks with large transaction arms that operate in the US via securities businesses -- Barclays, BNP, and Credit Suisse come to mind -- but we focus on the actual banks with a large transaction component, including:
- JPMorgan Chase (NYSE:JPM) Assets: $2.7 Trillion
- Citigroup (NYSE:C) Assets: $1.9 trillion
- Deutsche Bank AG (NYSE:DB) Assets: € 1.4 trillion
- Goldman Sachs Group (NYSE:GS) Assets: $925 billion
- Morgan Stanley (NYSE:MS) Assets: $876 billion
We also take a close look at the various loan asset classes on the balance sheets of US banks, particularly the real estate sector. Default rates continue to fall, except at the FHA were rates of delinquency are almost touch double digits. Meanwhile, volatility is returning to net loss rates for bank owned mortgages after years of suppressed loss given default (LGD). The chart below shows LGDs for the $2.5 trillion in bank owned 1-4s through Q2 2019.
We note that most of the Street was guiding lower on investment banking and trading revenue coming out of the second quarter of 2019, but falling NII may be a bigger problem. The Financial Times reports that investment banking revenues for the largest universal banks plunged to a 13-year low in 1H 2019, according to the latest data from industry monitor Coalition.
“The banks had individually reported poor second-quarter earnings for their markets and investment banking divisions, including an 18 per cent fall in fixed-income revenues at Morgan Stanley and a 32 per cent decline in equities revenues at Deutsche Bank, which is in the process of shutting its stock trading business,” the FT reports.
As we go into Q3 2019 earnings for US financials, remember that pricing power for bank loans is non-existent and the cost of deposits may not actually be moving lower with medium term interest rates. Our fiends at Sandler O’Neill noted last month:
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“Right now, the central question facing community bank managers is whether lower short rates will translate into lower deposit costs. In our view, lower short rates might provide some modest relief, but they won’t be a panacea. We say this because deposit rates are more a function of market dynamics than absolute rates.” |
Of note, JPM Chairman and CEO Jamie Dimon apparently told an audience at the Barclays conference this week that he sees full-year 2019 net interest income as down $500 million from previous guidance, with full-year NII at about $57 billion. This is a full $2 billion below the $59 billion run rate implied by 1H 2019 results. If we spitball JPM’s NII for 2019 at $57.5 billion, here’s how the chart looks below.
Dimon told the conference that next year could be worse, reports SeekingAlpha, with a possible cut of several billion in NII vs 2019. The bank, Dimon says, is prepping for the possibility of 0% interest rates. The 2012-2018 boom time in financials finally seems to have ended and with it the steady ascension of bank earnings into the sky.
Depending on the results from the transaction side of the house, the US banking industry could report significantly reduced earnings for the rest of 2019 and beyond. And the credit for this mess begins and ends with the FOMC. We recall the sage wisdom of George S. Moore in the wonderful 1987 book "The Banker's Life" as told by our friend Martin Mayer:
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"I've always agreed with Milton Friedman that the Federal Reserve was more responsible for the Depression than any collection of bankers or businessmen or politicians, but I don't think you can blame any individuals. In 1929, the Fed did not know what was happening. If they had known, they wouldn't have had any ideas of what to do about it, and if they'd known what to do there wasn't anybody around who could have done it." |
JPM CEO Jamie Dimon was smart enough to go long duration in Q3 2018, yet the leader of the largest universal bank in the world is now telling us that his carry on assets is falling. The carry on his $2 trillion portfolio of earning assets is falling. The logical endpoint of this situation is insolvency for the largest bank in the US.
Meanwhile, those brave souls in the world of mortgage lending and servicing who are actually short-duration are about to get annihilated in the third quarter. Could we see a down mark of $10 billion in mortgage servicing rights (MSRs) in Q3 2019 for the owners of the $120 billion in mortgage servicing? To paraphrase Rocket in "Guardians of the Galaxy":"Oh yeah."
If the guidance of JPM CEO Dimon does not adequately illustrate the insanity of negative interest rates, there is nothing else we can say. As a growing number of analysts are realizing, we must raise interest rates to save the global economy by restoring the carry on -- and thus the value of -- of financial assets. Any other course is collective suicide. Forget the Europeans and the Japanese. They are doomed. The US must lead the way out of the negative interest rate trap. But does Fed Chairman Jerome Powell have the courage to reject the past decade of Fed policy and lead the way?
EDITOR'S NOTE
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.
