Josh Rosner of Graham Fisher has graciously allowed us to republish their latest report on the outlook for banks and credit. Rosner was the first to warn of the dangers of allowing widespread mortgage lending with low down payments in his 2001 article: A Home Without Equity is Just a Rental With Debt. Rosner was the co-author with Gretchen Morgenson of Reckless Endangerment and describes himself as a “recovering GSE analyst.” From his analysis; the full document is embedded at the end of this post:
GF&Co - Banks, BDCs, C&I and the Yield Curve
This report is the first in an ongoing series in anticipation of the likely recession of Q3 2019
Memories are short and recent lessons are quickly unlearned. Market participants have so quickly forgotten that the financial crisis did not descend upon us out of nowhere. It was the result of seven-years of artificially low interest rates. It was the result of herding behaviors that reduced consideration of credit and liquidity risks coupled with demands, by investors, for instruments with higher yields than could be gotten on an unlevered basis. As a result, issuers benefitted from an ability to originate riskier loans and sell much of those volumes to charter constrained investors who forgot that “risk is the price you never thought you would have to pay”.
The Federal Reserve began raising rates in the third quarter of 2004 and, within 24 months banks had withdrawn liquidity to third party mortgage originators and had tightened underwriting standards. As liquidity reversed and homeowners lost their ability to refinance (on an economic basis) investors began to wake up to the withdrawal of liquidity and the risks of rising credit losses which then reinforced the negative feedback loop that claimed homeowners, investors, financial institutions and Main Street.
As investor appetite for securitized mortgage assets collapsed, and banks were neither able or willing to hold loans they once had either been able to package into MBS, or as the non-investment grade tranches of MBS packaged into CDOs, we then saw bank loan growth – long supported by mortgage origination and refinancing – collapse.
Now, ten-years later, as the Fed has begun to drain liquidity from the system, investors are ignoring structural changes in bank lending markets that have occurred during this economic expansion. If the Fed is successful in reshaping the yield-curve we will again be faced with new and expressible opportunities in many banks, private equity firms, business development corporations (BDCs) and underlying commercial credits. Assuming the Fed continues on its stated path we are approaching the prelude to one of the most significant distressed and restructuring cycles in modern history. As shown in the chart above, the lag between Federal Reserve rate hikes and their impacts on the real economy is usually 12-24 months. As a result, it is time to begin identifying the resulting current and future opportunities. We have begun to drill down into the specific exposures of the publicly traded BDCs and those banks which have been most reliant to C&I originations.
Rather than accepting utility-like returns, over the past decade, the banks sought new markets to exploit. Subprime auto loans and student lending, expense reductions and reserve release could provide some support of growth, but they would not support market expected top-line returns. But there was an asset class that could – commercial and industrial lending. On a ten-year basis, C&I has become the largest portfolio asset for the banking industry. (21.07% vs 20.73% for 1-4 family first liens)
Flight to Quality or Higher Short-Term Rates – the “E” of P/E may be at Risk
It is unfair to speak of “the banks” in monolithic terms, and we can identify specific banks that will buck the trends and prosper due to the uniqueness of their businesses. Broadly speaking, the reality is that bank loan growth is near its cyclical peak and expense cutting appears to be past its cyclical peak. As the Fed raises rates banks will continue to be forced to choose between paying more for deposits or losing those depositors – these pressures are already mounting. Cost cutting and reserve releases that helped the banks earlier in the cycle will become less accretive to earnings.
Caveat: It is worth noting that if one believes that the Fed is likely to change course out of concern for the domestic economy, or as a result of global instabilities, then the concerns stated here are premature and investors should be focused on a different set of risks to financial markets and financial institutions that were taught by the 1997 Russian Debt Crisis. As a result of the Russian Debt Crisis global capital flew to safety and flowed into the United States. The result was downward pressure on rates. This pressure had negative impacts on the gain on sale assumptions of thinly capitalized independent mortgage lenders and on bank MSRs. Given the consolidation of these businesses and changes to gain on sale accounting requirements these risks are diminished but, for a few of the largest banks, the impact on MSRs should be felt in downward revisions to earnings estimates.