Most banks will be reporting their first quarter earnings over the next few weeks and, spoiler alert, it ain’t gonna be pretty. For many, results will be characterized as “disappointing”, a small percentage may report “pleasant surprises”, but for a few the reports and investor calls will be downright ugly. Banks like First Republic (FRC), Western Alliance (WAL) and PacWest (PACW) that have been pummeled over the last month will have a chance to change the narrative, provide a compelling story, and restore investor and market confidence…or they won’t. The stakes are incredibly high for the sector as a whole, but for these three banks (and a few others) how they handle this quarter’s earnings announcements could be the difference between failure and long-term survival and prosperity. Is this hyperbole? Are we overreacting to the latest “crisis”? Perhaps, but no other industry sector is as sensitive to market confidence as banks. and right now that confidence is extremely low. Any additional negative surprises could cause another severe market reaction. In general, we believe that most banks will paint a cautious picture of the short- to intermediate-term environment. As a result, we expect most to focus on a few key issues -- deposits, net interest margin, credit quality, and expense management.
Deposits, Deposits, Deposits
It’s been a long time since bank CEOs and CFOs have paid any attention to deposits, other than trying to figure out how to squeeze every last penny from their cost of funds by driving rates paid to depositors to zero. After all, funds were plentiful thanks to all that pandemic related stimulus, significant corporate liquidity, and high household savings rates. And, while loan demand remained strong, volumes were still not sufficient to absorb all that funding. In fact, 2022 (and primarily the latter half) was the first time in four years that loan growth outstripped deposit growth, causing loan to deposit rates to begin to increase. While loan to deposit ratios remained below historical levels throughout 2022, we expect this ratio to increase above historical averages for the entire sector and for some banks to report ratios well above 100%.
So, what was a poor CEO supposed to do with all that excess liquidity, buy long-term government securities or put a lot of long-term jumbo low rate mortgages on the books? That would be irresponsible and, actually, too stupid for highly paid executives to even contemplate. Oh wait. So, it should be interesting, and somewhat entertaining, to listen to CEOs and CFOS who have neglected and taken their deposit portfolios for granted for, well, ever to tell us how much they care about their depositors and how they are doing everything possible to solidify and grow a strong and stable core deposit franchise. Ha!
Net Interest Margin
While information about net interest margins (NIM) is always a crowd pleaser, expect the news on this front to be “disappointing”. It’s true that many banks have reported relatively low margins over the past couple of years on a historical basis. However, while low rates have kept loan yields low for most banks, earnings have increased to record levels primarily because the cost of funds was zero and credit quality was pristine. Not so much anymore. All the banks that were saying their margins would benefit from a rising rate environment forgot one important detail – the NIM equation has two sides. And, few banks expected funding costs to increase more rapidly than their ability to reprice loans hence the confidence, some would say arrogance, to claim that rising rates would actually benefit their margins. Well, not so fast. Look for net interest margins in many banks to crash by as much as 30 to 50 basis points off of already low levels.
Credit Quality, Particularly Commercial Real Estate
The loan portfolios for many banks are heavily concentrated in commercial real estate. This is especially true for smaller regional and super community banks. In fact, real estate related credit (both personal and commercial) constitutes 47% of loan balances for the industry as a whole. For certain smaller banks that number is considerably higher. Sector concentration is always a problem, but this is one that most banks have glossed over and have not taken the necessary steps to create sufficient reserves to effectively manage the risk of a significant sector downturn. In fact, until the latter part of last year it was more likely to see banks releasing, rather than increasing, loan provisions. Now suddenly there is a lot of concern about banks’ commercial real estate exposure. The concern, of course, is that any significant market deterioration will have a negative earnings and capital impact as banks rebuild their reserves, especially as net interest margins come under pressure. However, this risk certainly should not have been unexpected. The CRE market has been a timebomb ready to explode ever since people started commuting through ZOOM, working in their pajamas, and leaving office space and office buildings vacant and abandoned. Many companies and firms did not reduce space because lease terms were onerous and penalties severe. However, as lease terms expire and renewals become troublesome it is possible, indeed likely, that the commercial property market, especially for non-prime properties, may come under pressure. The implications for a large portion of the banking sector could be severe. Consequently, expect analysts to suddenly find religion and ask a lot of questions, and demand a lot of information, on the size, composition and performance of the commercial real estate portfolio. Our First Quarter report (out at the end of April) will have an in depth look at which banks are particularly vulnerable to this market sector.
Expenses
Well, with margins down and credit risk accelerating there is really only one place for most banks to go to provide any positive guidance or hope, and that’s the tried-and-true refuge of expense reduction. Over the last few years, many banks have become lazy on expense discipline. Let’s face it, they didn’t have to: earnings were good, the balance sheet was growing, and bonuses were flowing. Why spoil the party by clamping down on expenses and making people unhappy. But now look for many of these banks to talk about expense management as if they have been worshipping at the feet of Scrooge all this time and have rigorous programs in place to reduce and manage noninterest expenses without harming the core business. It’s sad, but the call script almost writes itself. Here’s advice from somebody who has seen this come and go – don’t believe them. There are a few banks that have shown the ability to control expenses over time and produce superior efficiency ratios. These include Fifth Third (FITB), M&T (MTB), Regions (RF), East West (EWBC), and Bank OZK (OZK). If these banks discuss expense management programs, pay attention. Everybody else is just talk.
Is the Entire Banking Sector a Bargain?
We do not provide investment advice or try to predict and time market moves. We analyze the industry and the performance of individual banks and evaluate these banks on a relative, not absolute, basis. As a result, we believe the entire banking sector has been oversold and current valuations represent a significant discount to historical market multiples. However, our analyses have also shown us that not all discounts are created equal. First quarter earnings reports will help to separate fact from rumor, clarify the investment landscape, and help determine which companies represent a significant buying opportunity, and which should be approached with caution. As earnings are reported look for banks that have a strong, stable core deposit portfolio, have managed their balance sheet to protect against rising interest rates, have built a diversified loan portfolio, and have shown a consistent ability to control and manage noninterest expenses. Two of our 2022 top rated banks, MTB and OZK, match this profile and we believe are well positioned to further differentiate themselves. Others that we follow and believe will survive relatively unscathed are Regions, Fifth Third, East West Bancorp, and Webster. However, this market is not for the faint of heart. There remains considerable risk in the market, including the impact of a potential recession, that should be considered when making any investment decision. The following charts identify which of our banks performed best on both efficiency ratio and net interest margin in 2022 and which had potential risk because of their high loan to deposit ratios. (Note: We expect the NYCB loan to deposit ratio to decline significantly in the first quarter due to its takeover of the Signature Bank deposit portfolio from the FDIC.)
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