Why This Crisis Is Different

The USS Economy is steaming into dangerous waters and the country’s banks are trapped aboard with the rest of the passengers.

A public health policy of social distancing and lockdowns in response to the COVID-19 virus is creating a devastating impact on the U.S. economy, which in recent years has been driven by consumer spending and a historically low unemployment rate. According to the Bureau of Labor Statistics, the U.S. labor market added 273,000 jobs in February, while private sector wages grew 3%. Moody’s Investors Service also says that the U.S. economy grew 2.3% last year, with personal consumption expenditures contributing 77% of that growth.

That is changing very quickly. Brace yourself for the virus economy.

Wall Street firms are forecasting that the U.S. economy will contract sharply in the second quarter — with Goldman Sachs Group expecting a 24% decline in gross domestic product for the quarter.

“The sudden stop in U.S. economic activity in response to the virus is unprecedented, and the early data points over the last week strengthened our confidence that a dramatic slowdown is indeed already underway,” Goldman’s chief economist Jan Hatzius wrote in a March 20 research note.

My memory stretches back to the thrift crisis in the late 1980s, and there are others that have occurred since then. They’ve all been different, but they generally had one thing in common: They could be traced back to particular asset classes — commercial real estate, subprime mortgages or technology companies that were grossly overfunded, resulting in dangerous asset bubbles. When the bubbles burst, banks paid the price.

What’s different this time around is the nature of the underlying crisis.

The root cause of this crisis isn’t an asset bubble, but a public health emergency that is wreaking havoc on the entire U.S. economy. Enforced governmental policies like social distancing and sheltering in place have been especially hard on small businesses that employ 47.5% of the nation’s private workforce, according to the U.S. Small Business Administration. It puts a lot of people out of work when those restaurants, bars, hardware stores and barber shops are forced to close. Economists expect the U.S. unemployment rate to soar well into double digits from its current rate of just 3.5%.   

Bank profitability will be under pressure for the remainder of the year. It began two weeks ago when the Federal Reserve Board began cutting interest rates practically to zero, which will put net interest margins in a vice grip. One bank CEO I spoke to recently told me that every 25-basis-point drop in interest rates clips 4 basis points off his bank’s margin — so the Fed’s 150 basis point rate cut reduced his margin by 20 basis points. Worse yet, he expects the low-rate environment to persist for the foreseeable future.

Making matters worse, banks can expect that loan losses will rise over time — perhaps precipitously, if we have a long and deep recession. Many banks are prepared to work with their cash-strapped borrowers on loan modifications to get them through the crisis; federal bank regulators have said lenders will not be forced to automatically categorize all COVID-19 related loan modifications as troubled debt restructurings, or TDRs.

Unfortunately, a prolonged recession is likely to outpace most banks’ abilities to temporarily forego principal and interest payments on their troubled loans. A sharp rise in loan losses will reduce bank profitability even more.

There is another way in which this crisis is different from previous crises that I have witnessed. The industry is much stronger this time around, with roughly twice the capital it had just 12 years ago at the onset of the subprime mortgage crisis.

Think of that as first responder capital.

During the subprime mortgage crisis, the federal government injected over $400 billion into the banking industry through the Troubled Asset Relief Program. The government eventually made a profit on its investment, but the program was unpopular with the public and many members of Congress. The full extent of this banking crisis remains to be seen, but hopefully this time the industry can finance its own recovery.

The Mixed Blessing of Bank Deposits


mixed-blessing.jpgThe U.S. banking industry is drowning in deposits and that’s not necessarily a good thing. As of June 30, deposits in U.S. banks (but excluding credit unions) totaled $8.9 trillion, up nearly 8.5 percent from June 30, 2011, according to the Federal Deposit Insurance Corp. Total bank deposits have actually increased every year since 2003, although the increase from 2011 to 2012 was the sharpest jump over that time.

There’s no great mystery why this is happening. The U.S. economy’s uncertain outlook and a volatile stock market has led many consumers and businesses to park their investment funds in insured deposit accounts rather than risk losing a big chunk in another market meltdown. Normally banks would be quite happy to have a surfeit of low-cost deposit funding, but it’s actually something of a mixed blessing nowadays. Slack loan demand and low rates of return on investment securities like U.S. Treasuries, the latter a direct result of the Federal Reserve’s easy money policy in recent years that has kept interest rates low, are making it very difficult for banks to earn a decent return on all those deposits.

What makes this multi-year increase in deposits so interesting is that it has occurred at the same time banks have been closing branches and pruning their networks. As of June 30, according to the FDIC, there were 97,337 bank branches nationwide, down from a high of 99,550 in 2009, and there has been a consistent year-over-year decline since then. There’s no mystery why this is happening either. Two seminal events since 2010—new restrictions on overdraft charges and a cap on debit card fees—have taken a big bite out of the profitability of most retail banking operations and banks have responded by cutting costs, partly through layoffs but more so through branch closings. That deposit levels have continued to rise, even as the number of branches has declined, has no doubt made it easier for banks to trim their brick-and-mortar networks.

But here’s the rub. What happens if in a few years the U.S. economy makes a strong comeback and retail investors are once again confident enough to put their money into the stock market? Banks don’t have to compete with the stock market now for consumer funds, but they would in that scenario. Most banks have developed multi-channel distribution systems with the traditional branch as the hub and alternatives like automated teller machines, in-store branches, the Internet and more recently the mobile phone as spokes. And while remote channels like online and mobile have steadily grown in popularity in recent years, how effective will they be as deposit gathering tools if banks must once again compete for funds?

Here’s my best guess at what the future holds: Don’t be surprised if, say, five years from now the trend has reversed itself and banks are once again opening new branches.  It might be like a relic of days gone by, but a deposit war between Main Street and Wall Street would be just the thing to give the hoary old bank branch a new lease on life.

Bank stocks plummet: It’s the economy, stupid.


stock-plummet.jpgThe stock market has been filled with irony (not to mention misery) lately.

Investors flocked to the safety of U.S. Treasuries, despite the fact that Standard & Poor’s had just downgraded the U.S. debt rating late Friday.

Bank of America led the market’s precipitous decline on Monday, falling 20 percent to $6.41 per share, on news that AIG was suing the bank for the insurance company’s financial problems.

The Dow Jones Industrial Average fell 5.6 percent Monday to 10,810, following last week’s biggest weekly drop since 2008, then surged in early trading Tuesday as bargain hunters came calling.

The Keefe Bruyette & Woods Bank Stock Index, which consists mostly of large-cap banks, fell 10.7 percent Monday and then recovered somewhat by gaining 7 percent the next day.

The stock market pundits had been talking about what little impact the S&P downgrade would have, and investors reacted by abandoning stocks instead.

Analysts at KBW say what’s really happening is investors are worried about the economy, not the downgrade, and that doesn’t bode well for financial stocks.

But ironically, there was no new news about the economy to warrant such a free fall, only news about the debt rating.

Perhaps investors are beginning to believe the recovery will be slow to nonexistent for a long time and it took until late summer for that to sink in. There’s also the fact that many of them have the equivalent of “panic button” orders to sell when stocks fall below a certain point.

Bank stocks often take the biggest hit when the economy falters. High unemployment and low consumer confidence means fewer loans for everything from homes to shopping centers. Plus, many of the largest banks in the country have a lot of earnings exposure to the world’s stock markets, in the form of investment banking and trading revenues.

And as banks cut back on expenses because revenue is tight, so will they cut back on employment, as evidenced by a Bloomberg News breakdown of where all the job losses will be in banking.

Scott Brown, chief economist at Raymond James & Associates, said in his weekly commentary that: “Many commercial banks, for example, have large holdings of Fannie Mae and Freddie Mac debt. These banks may, in turn, move to boost capital and reduce lending to consumers and businesses,” as a result of the debt downgrade.

Predictably, investors are being told not to panic, just at a time when it seems like everyone is panicking.

Even analysts at S&P, whose downgrade was surrounded by so much tumult, said they thought stocks have been “oversold,” and that the U.S. will likely avoid another recession, according to Forbes.

Jerry Webman, chief economist at Oppenheimer Funds in New York, told ABC News: “The most important thing for people to do right now is to take a deep breath, whether you’re reacting to the latest, pretty good job numbers or you’re still in shell shock from everything else we’ve learned in the last week.”

Sigh.