Even as a record 50 million Americans hit the road for Thanksgiving last week, the Federal Deposit Insurance Corp released the Q3 2019 financial results for the US banking industry, reminding us why reading the press on holidays is essential.
Headline: Bank earnings are falling and have been since last year. But hold that thought…
Below we look at several charts that tell the story as the US heads into year end 2019.
Perhaps the most significant change from last quarter was the fact that loss given default (LGD) for the $2.5 trillion in 1-4 family mortgage loans owned by banks reversed direction as home prices surged again, reaching a record low of -38% in the third quarter. Think of falling resolution costs as the inverse of home price appreciation.
Memo: Send another thank you note to Fed Chairman Jay Powell.
Gross charge-offs in 1-4s also fell to a post 2008 financial crisis low, confirming that credit conditions in the housing sector continue to appear benevolent, but also badly skewed compared. Of note, the long-term average LGD for bank owned 1-4 family mortgage notes over the past half century is 65%.
The impact of monetary policy, a shortage of new and existing dwellings and a change in the behavior of older home owners has created a perfect storm of rising home prices and declining affordability.
As a result of the increase in home prices, when those rare residential mortgage default events actually occur, the lenders profit on the resolution of the asset, as shown in the chart below. For many Americans, the dream of home ownership is simply no longer possible. A future of tenancy and insecurity awaits.
The chart above suggests that lending on prime 1-4 family homes has no cost in terms of credit, clearly an erroneous statement. Yet looking at the extraordinarily good credit performance of bank-owned 1-4s, it seems that those bearish warnings from some quarters of an impending recession in 2020 may have been a tad overstated.
In prime auto loans held by banks, to look at another consumer facing sector, there is likewise evidence of stability in credit metrics. LGDs for auto loans fell below 50% for the first time since 2014. The average LGDs for bank owned auto loans is 56% going back to 2012, when the FDIC started requiring banks to break out this important consumer loan category in their quarterly disclosure.
All that said, the trend in terms of net charge-offs and past due of bank owned auto loans continues to move higher, as shown in the chart below.
The next chart we selected from the Q3 2019 data from the FDIC is the net growth of total deposits and total loans, one of the most important relationships in terms of the overall condition of the US economy. In the period immediately leading up to the 2008 financial crisis, the rate of growth in deposits and therefore loans were quite high by historical standards.
Then, following the 2008 crisis, the level of loans and deposits fell sharply as the industry took over $100 billion in losses that year, destroying both bad loans and the related deposit liabilities. Notice the huge downward skew in loans in Q4 2009, when the industry charged off $60 billion in bad loans in a single quarter.
Since then however, despite or even because of the radical policies followed by the Federal Reserve Board, the level of deposit and lending growth rates have fallen, as shown in the chart below. The graphic shows the period end portfolio levels of loans and deposits, net of redemptions and new originations.
Finally, to return to that question about bank earnings, we take a look at after-tax bank results, both in terms of asset and equity returns. As we have been writing for almost two years in The Institutional Risk Analyst, the steady increase in bank funding costs have slowed and now reversed the steady growth in bank income since 2008. The one time increase in “returns to us” caused by the 2017 tax legislation is now long behind bank stock investors.
Our friends in the worlds of asset management and financial journalism have trouble describing a decline in income to their various constituencies, but the numbers tell the tale very simply. US banking Industry net income peaked at almost $62 billion in Q3 2018 and has now fallen to $57.3 billion last quarter. That’s a ten percent decline, but you rarely read or hear that fact in the financial press. We must always be constructive, even if it means misleading the investing public.
While the rate of increase in bank interest expense has slowed since Q2 2019, the deterioration in bank asset and equity returns is clear. Including large markdowns of mortgage servicing assets, "the average return on assets declined from 1.41 percent in third quarter 2018 to 1.25 percent," notes the FDIC. But the "one-time" events do not explain the downward trend in bank earnings. The peak of bank asset and equity returns was Q3 2018 at 14.8% and 1.4%, respectively. Income is falling, but the total assets of the industry continue to rise. The chart below shows asset and equity returns for all US banks.
The bottom line is credit quality in the US banking industry remains strong -- if you believe the data. The skew in home prices for the reasons described above raise doubts about the long-term credit cost of loans being originated today. It is interesting, of note, to see the LGDs for Commercial & Industrial loans and Total Bank Loans climbing, suggesting a slow but steady deterioration in credit quality is underway outside of the badly skewed world of residential housing.
More troubling, however, is the lack of net growth in spreads on new lending and the secular decline in deposit growth rates since the Fed instituted “quantitative tightening” two years ago. The cessation in QT and the sharp reversal by the FOMC to add back liquidity to the money markets has not yet delivered an increase in domestic bank deposit growth rates. Without deposit growth, you cannot have strong loan growth – contrary to what many economists seem to believe.
The continued increase in bank funding costs, regardless of what the Fed does or does not do, will remain a negative factor affecting bank earnings. Even with the change in direction of US monetary policy since the end of 2018, the pressure on bank earnings continues both due to rising funding costs and secular pressure on asset returns in the age of negative interest rates. A decade since the financial crisis, US banks have still not recovered to previous levels of asset and equity returns and are now losing ground.
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.