COVID | Credit | Equities | US
All things considered, the economic recovery post Covid lockdown has been stronger than many analysts expected a few months ago. The CARES Act did much to shield people and businesses from the worst of the lockdowns and economic collapse. The labour market is still in shambles, but consumer spending and housing – two engines of US GDP – are above pre-Covid levels, and purchasing manager surveys suggest that Corporate America is back in business.
Add solid credit performance to the list. Third quarter bank reports from Citigroup (C) and JP Morgan (JPM) show virtually no hit yet to bank loan portfolios from realized loan losses. And despite numerous anecdotes of small businesses folding and millions of people on the brink of disaster financially, bankruptcies remain at pre-Covid levels.
Granted these are lagging indicators. And there are some warning signs that things will probably worsen in coming months. Whether that amounts to a modest uptick or something worse will probably depend on whether and when further stimulus legislation passes and how big it is.
Bank Loan Portfolios Show Little Sign of Stress
At this writing, JPM and C have reported third quarter earnings. Focusing on their loan portfolios, one standout is that charge-offs (or realized loan losses) for both banks remain at pre-Covid levels (Table 1). Both banks made massive additions to their loan loss reserves in the first and second quarters, causing loss reserves to jump roughly 2pp. But so far there is little sign of corresponding loan losses.
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Summary
- Bank 3Q earnings reports show realized credit losses have yet to rise above pre-Covid levels. Bankruptcy data shows similar pattern.
- Credit deterioration a lagging indicator and likely to worsen in coming months – but possibly may be better than many feared.
- Earnings reports less constructive elsewhere: banks face growing profit pressure from low rates and shrinking NIMs; loan portfolios also shrinking; and there is little visibility on when banks can resume normal dividends and share buybacks.
Market Implications
- Short term – Positive for equities exc. banks. Good credit quality data supports upward trajectory view of economy. Banks continue to underperform due to curtailed dividends and share buybacks.
- Medium term – Depends on timing and size of any stimulus package. Equities vulnerable if package small or delayed. Bonds vulnerable to selloff if package large due to supply.
- Long term – Positive for bank equities as normal dividends and share buybacks resume.
All things considered, the economic recovery post Covid lockdown has been stronger than many analysts expected a few months ago. The CARES Act did much to shield people and businesses from the worst of the lockdowns and economic collapse. The labour market is still in shambles, but consumer spending and housing – two engines of US GDP – are above pre-Covid levels, and purchasing manager surveys suggest that Corporate America is back in business.
Add solid credit performance to the list. Third quarter bank reports from Citigroup (C) and JP Morgan (JPM) show virtually no hit yet to bank loan portfolios from realized loan losses. And despite numerous anecdotes of small businesses folding and millions of people on the brink of disaster financially, bankruptcies remain at pre-Covid levels.
Granted these are lagging indicators. And there are some warning signs that things will probably worsen in coming months. Whether that amounts to a modest uptick or something worse will probably depend on whether and when further stimulus legislation passes and how big it is.
Bank Loan Portfolios Show Little Sign of Stress
At this writing, JPM and C have reported third quarter earnings. Focusing on their loan portfolios, one standout is that charge-offs (or realized loan losses) for both banks remain at pre-Covid levels (Table 1). Both banks made massive additions to their loan loss reserves in the first and second quarters, causing loss reserves to jump roughly 2pp. But so far there is little sign of corresponding loan losses.[1]
In addition, Citigroup reported little change in delinquencies in its consumer loan portfolio, both on a 30-89 day and 90+ day basis.
Balanced against this overall favourable picture, loans in non-accrual status have risen at both banks throughout 2020. Most of these will be charged off in coming quarters, implying charge-off rates will rise. However, loan loss reserves have risen more rapidly, so at this point the banks appear to have a substantial cushion to absorb any future losses without adversely affecting earnings.
Other Sources Tell a Similar Story
Other sources confirm that credit losses remain low. Federal Reserve data on system-wide bank loan delinquencies and charge-offs show little change (although it only covers through the second quarter, Chart 1).[2]
And, surprisingly, bankruptcy filings appear to have actually declined in 2020 compared with the past five years (Chart 2).
Another point to note in both these charts is how high delinquencies and charge-offs were during the late 1980s when the thrift industry collapsed; and how credit statistics deteriorated during and after the GFC. Given the impact of the Covid-related lockdowns and ongoing need for social distancing, there had been concerns that the US economy could be facing a similar wave. That scenario looks less likely now.
A Few Caveats…
We noted at the onset that credit deterioration is a lagging indicator. Apart from a usual lag, the stimulus effects from the CARES Act[3] also did much to shield people from the worst of the lockdown-related economic collapse. Various forbearance programs have also helped. And the need to conduct most court proceedings remotely may have slowed bankruptcy filings and proceedings. Still, it is surprising that we aren’t seeing more nascent signs of emerging stress.
The bottom line is that credit losses and bankruptcies will rise at some point. Whether it turns out to be a modest uptick or something worse will depend on the size and timing of any forthcoming stimulus legislation.
Banks Still Face Challenges
It may be several quarters before we see whether banks have already provided for likely credit losses, but the earnings reports so far show that they face other earnings pressures because of the Covid economy.
First, net interest margins (NIMs) at both C and JPM have fallen about 10% from pre-Covid levels because interest revenue has fallen much faster than interest revenue. As long as rates remain low, NIMs will be under downward pressure.
Second, both banks report declining loan balances. There was a surge of loan growth in the first quarter as many companies drew down lines of credit to deal with Covid-related emergencies. Since then loans outstanding dropped 8.5% at C and 6.6% at JPM. Year-over-year, loans are down 6% and 1% at C and JPM, respectively. To put it another way, banks (or at least these two) are not out financing the next wave of American GDP growth. That could change in coming months, but until it does, further GDP growth will be sluggish at best.
Third, there is little visibility on when banks will be able to resume normal dividends and share buybacks. That has been a key factor in bank equity underperformance in 2020 and will likely continue to be a headwind until banks can resume normal payouts.
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Briefly, banks account for rising credit problems in several steps. If loan losses are expected to rise above normal levels, a loss provision is made, recognized in income, and added to the loan loss reserve. When a loan actually goes bad and is written off, it is removed from the loan portfolio, and the loss reserve is reduced by the amount of the loss or charged off. The charge-off does not affect income. If ultimate charge-offs are lower than expected, reserves may be released (or reduced) and recognized in income. ↑
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Charge-offs are considerably lower than delinquencies partly because some delinquencies are cured and return to normal status, and partly because many loans are collateralized, reducing the total loss. ↑
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Coronavirus Aid, Relief and Economic Security Act, signed into law in March 2020. ↑
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)