- A benign credit environment paints a better picture for banks — large banks in particular — than trade and interest rate headlines suggest.
- Most of the credit risk banks face looks to be at small banks, which have more exposure to commercial real estate loans.
- Increased mortgage originations due to lower rates should be an incremental positive for those banks in the residential mortgage business.
Credit Is Not a Worry Yet
Trade concerns and the growing likelihood of an interest rate cut have weighed on banks lately, causing a pullback after a stellar start to the year. As proxies for broad economic activity, banks saw their shares retreat as higher U.S. tariffs on Chinese goods came into force in May, followed by increased threats of further measures from both sides and the possibility of tariffs on Mexican goods. These developments have dampened the outlook for global economic growth.
Yet there are some positive catalysts for banks, chief among them a benign credit environment, which paints a better picture for banks — large banks in particular — than trade and interest rate headlines suggest. We believe the benign credit environment is significant and should be a meaningful catalyst. In particular, data from the FDIC show no signs of credit stress in consumer lending or commercial lending. While for most banks there was a slight uptick in delinquencies (30–89 days past due) in the first quarter, the increase seems consistent with normal seasonal trends (Exhibit 1).
Exhibit 1: Percent of Loans & Leases 30–89 Days Past Due
Further, noncurrent loans are down and industry losses are near all-time lows, a scenario consistent with credit trends across the economy. Although loan-loss reserves (expenses set aside to cover potential losses from uncollected loans) have declined since the financial crisis, coverage ratios have improved dramatically (Exhibit 2).
Exhibit 2: Reserve Coverage Ratio
Most of the credit risk banks face looks to be at small banks, and for a few reasons. Smaller banks have greater exposure to commercial real estate loans, which typically entail more credit risk than other types of loans (Exhibit 3). Small banks are also more likely to participate in risky loan syndications. And, in some cases, their relative lack of underwriting expertise and financial clout reduces the influence small banks can have on loan terms and pricing.
Exhibit 3: Commercial Real Estate Loans as a Percentage of Total Loans
Lower long-term interest rates have been a concern for bank stock investors since the Fed’s accommodative turn early in 2019; these and concerns about trade wars have resulted in a sharp increase in the probability of a rate cut by the Fed in just the last two weeks. The Fed Chairman has made it clear the Fed will cut rates to support economic growth. Yet there are still signs of economic health and expansion from both the consumer and business sides of the economy. The U.S. economy grew by 3.1% in the first quarter, above expectations, and although many economists forecast slower growth over the next year, GDP growth is still generally forecast to remain over 2%. The 10-year U.S. Treasury yield and inflation have fallen in 2019, though inflation did increase in April.
For some banks, there are benefits to lower interest rates. For one, lower rates have helped create an uptick in mortgage applications in 2019, particularly in April and May. While higher refinancing activity may not fully offset pressure on net interest margins from lower rates, increased originations should be an incremental positive for those banks in the residential mortgage business. Higher refinancings should generate some gains for lenders, although there may be some negatives here too, namely servicing write-downs as prepayments increase, which should be partially offset by hedging gains. In addition, lower long-term rates will eventually reduce the yields on banks’ securities and loans, depending on how much rates decline.
Multi-year high mortgage applications are likely a net positive for banks, and given the current level of delinquencies, charge-offs and bank de-risking since the financial crisis, credit does not seem likely to be a big issue for large banks and should not in the event of even a modest economic downturn. U.S. tariffs on Mexico, should they resurface, would raise valid concerns about overall economic activity, but many large U.S. banks, such as JPMorgan Chase and Bank of America, have very little exposure to loans to Mexican companies or consumers. While the possibility of an interest rate cut has increased, there are still some positives for large U.S. banks, as modest growth, low but steady inflation and low rates make for a supportive environment for bank credit.