Can the Industry Handle the Truth on Credit Quality?

Maybe Jack Nicholson was right: “You can’t handle the truth!”

The actor’s famous line from the 1992 movie “A Few Good Men” echoes our concern on bank credit quality in fall 2019 and heading into early 2020.

Investors have been blessed with record lows in credit quality: The median ratio of nonperforming assets (NPA) is nearly 1%, accounting for nonperforming loans and foreclosed properties, a figure that modestly improved in the first half of 2019. Most credit indicators are rosy, with limited issues across both private and public financial institutions.

However, we are fairly certain this good news will not last and expect some normalization to occur. How should investors react when the pristine credit data reverts to a higher and more-normalized level?

The median NPA ratio between 2004 and 2019 peaked at 3.5% in 2011 and hit a record low of 60 basis points in 2004, according to credit data from the Federal Deposit Insurance Corp. on more than 1,500 institutions with more than $500 million in assets. It declined to near 1% in mid-2019. Median NPAs were 2.9% of loans over this 15-year timeframe. The reversion to the mean implies over 2.5 times worse credit quality than currently exists. Will investors be able to accept a headline that credit problems have increased 250%, even if it’s simply a return to normal NPA levels?

Common sense tells us that investors are already discounting this potential future outcome via lower stock prices and valuation multiples for banks. This is one of many reasons that public bank stocks have struggled since late August 2018 and frequently underperform their benchmarks.

It is impressive what banks have accomplished. Bank capital levels are 9.5%, 200 basis points higher than 2007 levels. Concentrations in construction and commercial real estate are vastly different, and few banks have more than 100% of total capital in any one loan category. Greater balance within loan portfolios is the standard today, often a mix of some commercial and industrial loans, modest consumer exposure, and lower CRE and construction loans.

Median C&I problem loans at banks that have at least 10% of total loans in the commercial category — more than 60% of all FDIC charters — showed similar trends to total NPAs. The median C&I problem loan levels peaked at 4% in late 2009 and again in 2010; it had retreated to 1.5%, as of fall 2019. The longer-term mean is greater due to the “hockey stick” growth of commercial nonaccrual loans during the crisis years spanning 2008 to 2011, as well as the sharp decline in C&I problem loans in 2014. Over time, we feel C&I NPAs will revert upward, to a new normal between 2% to 2.25%.

Public banks provide a plethora of risk-grade ratings on their portfolios in quarterly and annual filings, following strong encouragement from the Securities and Exchange Commission to provide better credit disclosures. The nine-point credit scale consists of “pass” (levels 1 to 4), “special mention/watch” (5), “substandard” (6), “nonperforming” (7), “doubtful” (8) and “loss” (9, the worst rating).

They define a financial institution’s criticized assets, which are loans not rated “pass,” indicating “special mention/watch” or worse, as well as classified assets, which are rated “substandard” or worse. The classified assets show the same pattern as total NPAs and C&I problem loans: low levels with very few signs of deterioration.

The median substandard/classified loan ratio at over 300 public banks was 1.14% through August 2019. That compared to 1.6% in fall 2016 and 3.4% in early 2013. We prefer looking at substandard credit data as a way to get a deeper cut at banks’ credit risk — and it too flashes positive signals at present.

The challenge we envision is that investors, bankers and reporters have been spoiled by good credit news. Reversions to the mean are a mathematical truth in statistics. We ultimately expect today’s good credit data to revert back to higher, but normalized, levels of NPAs and classified loans. A doubling of problem credit ratios would actually just be returning to the historical mean. Can investors accept that 2019’s credit quality is unsustainably low?

We believe higher credit problems will eventually emerge from an extremely low base. The key is handling the truth: An increase in NPAs and classified loans is healthy, and not a signal of pending danger and doom.

As the saying goes: “Keep Calm and Carry On.”

This Is a Red Flag for Banks


yield-curve-7-5-19.pngThe yield curve has been in the news because its recent gyrations are seen as a harbinger of a coming recession.

The yield curve is the difference between short- and long-term bond yields. In a healthy economy, long-term bond yields are normally higher than short-term yields because investors take more risk with the longer duration.

In late June, however, the spread between the yield on the three-month Treasury bill and the 10-year Treasury note inverted—which is to say the 10-year yield was lower than the three-month yield.

Inverted Yield Curve.png

An inverted yield curve doesn’t cause a recession, but it signals a set of economic factors that are likely to result in one. It is a sign that investors lack confidence in the future of the economy. Or to put it another way, they have greater confidence in the economy’s long-term prospects than in its near-term outlook.

Long-term yields drop because investors want to lock in a higher return. This heightened demand for long-dated bonds allows the U.S. Department of the Treasury to offer lower yields. The historical average length of recessions is about 18 months, so a 10-year Treasury note takes investors well beyond that point.

Short-terms Treasury yields rise because investors are skittish about the economy’s near-term prospects, which requires the Treasury Department to entice them with higher yields.

It turns out that inverted yield curves have a pretty good track record of predicting recessions within the next 12 months. The last six recessions were preceded by inverted yield curves, although economists point out that inversions in 1995 and 1998 were not followed by subsequent downturns. And more than two years passed between an inversion in December 2005 and the onset of the 2008 financial crisis.

Still, an inverted yield curve is an economic red flag for banks. The industry’s performance inevitably suffers in a recession, and even the most conservative institutions will experience higher loan losses when the credit cycle turns.

An inversion is a warning that banks should tighten their credit standards and rein in their competitive impulses. Some of the worst commercial loans are made 12 to 18 months prior to an economic downturn, and they are often the first loans to go bad.

Ironically, if banks tighten up too much, they risk contributing to a recession by cutting off the funding that businesses need to grow. Banks make these decisions individually, of course, but the industry’s herd instinct is alive and well.

It’s possible that the most recent inversion presages a recession in 2020. In its June survey, the National Association of Business Economics forecast the U.S. economy to grow 2.6 percent this year, with only a 15 percent chance of a recession. But they see slower growth in 2020, with the risk of a recession by year-end rising to 60 percent.

This has been an unprecedented time for the U.S. economy and we seem to be sailing through uncharted waters. On July 1, the economy’s current expansion became the longest on record, and gross domestic product grew at a 3.1 percent annualized rate in the first quarter. Unemployment was just 3.6 percent in May—the lowest in 49 years—while inflation, which often rises when the economy reaches full employment because employers are forced to pay higher salaries to attract workers, remained under firm control.

These are historic anomalies, so maybe the old rules have changed.

The Federal Open Market Committee is widely expected to cut the fed funds rate in late July after raising it four times in 2018. That could both help and hurt bankers.

A rate cut helps if it keeps the economic expansion going. It hurts if it makes it more difficult for banks to charge higher rates for their loans. Many banks prospered last year because they were able raise their loan rates faster than their deposit rates, which helped expand their net interest margins. They may not benefit as much from repricing this year if the Fed ends up cutting interest rates.

Is an inverted yield curve a harbinger of a recession in 2020? This economy seems to shrug off all such concerns, but history says yes.

Creating Liquidity: Alternatives To Selling The Bank



Executives and boards of private banks have to think outside the box if they want to create a path to liquidity for shareholders that doesn’t require selling the bank. In this video, Eric Corrigan of Commerce Street Capital outlines three liquidity alternatives to consider, and shares why a proactive approach can help a bank control its own destiny.

  • Challenges in Creating Liquidity
  • Three Liquidity Alternatives
  • Benefits and Drawbacks to Each Solution
  • Questions Boards Should Be Asking

Investors Weigh In On Growth



A panel of three leading banking analysts from top research and brokerage firms share their insights and views on trends specific to financial institutions during Bank Director’s 2014 Acquire or Be Acquired conference in January. Moderated by Gary R. Bronstein, partner with law firm Kilpatrick Townsend & Stockton LLP, the panel discusses what bank investors consider key in terms of building a strong and profitable business.

Video Length: 46 Minutes

About The Speakers

Gary Bronstein is a partner with Kilpatrick Townsend & Stockton LLP. Gary provides a broad spectrum of strategic advice to financial institution and public company clients. He concentrates on initial public offerings and other specialized public and private capital raising transactions, M&A, proxy contests and a host of other corporate and securities law matters that arise during the life of clients.

Jefferson Harralson is the managing director, financial institutions research at Keefe, Bruyette and Woods a Stifel Company. Mr. Harralson joined KBW in 2002 and is responsible for its small and mid cap bank research groups. In 2012, Mr. Harralson was ranked as the nation’s 2nd leading regional bank analyst according to a Greenwich survey of 216 buy side firms. Mr. Harralson also heads Keefe Bruyette Woods’ southeastern bank research team, writing on 15 banks, ranging from community banks to Bank of America.

Ken Usdin is a managing director and senior research analyst at Jefferies LLC covering the U.S. banking industry. Mr. Usdin joined Jefferies LLC in 2010 and has over eighteen years of experience within the financial services industry, including fifteen years in equity research. Prior to joining Jefferies LLC, Mr. Usdin spent six years at Bank of America Merrill Lynch covering regional banks and trust/custody banks.

William Wallace is the vice president, equity research at Raymond James & Associates, Inc. He joined Raymond James in April 2011 through the acquisition of Howe Barnes Hoefer & Arnett, which he joined in October 2010. Mr. Wallace is responsible for coverage of banks and thrifts primarily located in the Mid-Atlantic and Southeast. Previously, he was an assistant vice president at FBR Capital Markets, where he assisted in the coverage of primarily mid and large cap regional and super-regional banks and thrifts. Mr. Wallace began his equity research career in 2004 at BB&T Capital Markets.