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Loans to businesses: the Achilles heel of the US economy

THE ESSENTIAL

The past few weeks have seen growing investor concerns on banks, including of US banks. This contrasts with the excellent year, the banking sector had in 2015 in terms of profits and its better capitalisation and higher liquidity reserves than before the crisis. What accounts for this mistrust? Two fears are being voiced: (1) investors are increasingly sceptical of the banks’ capacity to generate earnings in the future and (2) doubts about the quality of bank balance sheets are multiplying.

The growth outlook for bank profits has in fact deteriorated. The recent recordsetting profits were fuelled by the robust growth of the lending business, the low level of provisions and a sharp reduction in costs; these underlying factors will fade in the quarters to come. In addition, earnings growth will be dampened by even more stringent regulations and a protracted environment of low interest rates.

Against this backdrop, investors are very concerned about the quality status of loan portfolios and fear the consequences higher defaults in the energy sector and car and student loan delinquencies. We are not particularly worried about the direct effects. The indirect effects are a greater concern: this new increase in loans entering default could adversely affect growth, impact the credit quality assessment of other loans and culminate in the tightening of financing conditions across the entire US economy. The high debt accumulated by corporations may grease the wheels for a domino effect. However, at this point in time, the chances of such a scenario emerging in the next few months are slim.

 

2016-03-22-loans to businesses

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The past few weeks have seen growing investor concerns on banks, including of US banks. This contrasts with the excellent year, the banking sector had in 2015 in terms of profits and its better capitalisation and higher liquidity reserves than before the crisis. What accounts for these concerns? Two fears are being voiced: (1) investors are increasingly sceptical of the banks’ capacity to generate earnings in the future and (2) doubts about the quality of bank balance sheets are multiplying.

The profits of US banks under pressure

US banks just wrapped up an exceptional year in terms of profits. The combined net income of the eight largest banking institutions (JPMorgan Chase, Bank of America, Wells Fargo, Goldman Sachs, Citigroup, Morgan Stanley, State Street and Bank of New York Mellon) was more than $90bn in 2015. Nonetheless, investors expect the overall profitability of banks to deteriorate. It is important to understand that these record-setting profits were fuelled in recent years by:

  • sustained growth in the portfolio of car, student and, in particular, business loans.
  • lower provisions and losses recognised in bank income statements. This is the result of an improvement in bank asset quality and lower funding costs.
  • cost cutting. In fact, banks have multiplied their cost efficiency efforts these last few years. Total payroll at Bank of America was reduced by 10,000 jobs last year. Morgan Stanley eliminated 1,200 jobs, just one of many measures that allowed the bank to reduce costs by 10% in a year.

However, the benefit of these cyclical factors is expected to fade in the coming quarters and the environment has definitely become less favourable for earnings growth.

  • New financial regulations require financial institutions to cut back their speculative activities which prior to the crisis had made them a fortune. From a more cyclical standpoint, investor fear that the current market conditions, disastrous for brokerage activities, will continue. This instability is being fuelled by increasing uncertainty about world growth, the plunge in oil prices and distortions in the prices of financial assets generated by monetary policies. Fixed income, currencies and commodities trading has been particularly hard hit. In the fourth quarter of 2015 alone, the revenue from “Fixed Income, Currencies & Commodities” or FICC trading for the five largest banks active in this segment plummeted between 7% and 15% relative to Q4 2014. The banks now have to find new growth drivers.
  • Low interest rates have been a drain on the profitability of lending activities. Profits generated by lending come from net interest margin, that is, the difference between the interest rate at which a bank lends and its funding cost (financial liabilities or from their deposit base). These earnings are therefore sensitive to the absolute interest rate level and to the spread between long-term and short-term rates. Since 2008, the net interest spread has considerably narrowed. Market participants justifiably fear that this trend could accelerate. Markets are expecting two Fed funds rate hikes in 2016- 2017, whereas they were expected at last three by the end of Q3 2015. There has been talk of a further cut in key interest rates and even a negative deposit facility rate. Interest rate dynamics don't lie: the US 10-year bond yield has been hovering around 1.7% – an all-time low – and the yield curve has considerably flattened. Against this backdrop, the latitude available to banks for generating profits has been considerably reduced.

Regulations and the protracted low interest rate environment are adversely affecting the growth prospects of banks. Investors are well aware that the cost-cutting strategy adopted by most financial institutions is not a long-term solution.

A us banking system that is overall more robust than before the crisis

The eight major systemic banking groups (JPMorgan, Bank of America, Citigroup, Wells Fargo, Morgan Stanley, Goldman Sachs, State Street and Bank of New York Mellon) have tripled their capital (Tangible Common Equity) since late 2008, which at the end of 2015 stood at more than 800 billion dollars. Given their size and systemic importance, the US regulator is imposing high capital buffers on systemic banks.

The US regulator subjects the banks to an annual stress test (the Comprehensive Capital Analysis and Review - CCAR). During this exercise, the regulator tests their resilience against scenarios adapted to the economic cycle and current major risks. The outcome determines the payment of dividends to shareholders and forces banks to adopt a disciplined capital strategy and to moderate their risk exposure. 

The crisis of 2008 and the introduction of stricter banking regulations have resulted in a more concentrated US banking system. In late 2015, the big eight American banks had an aggregate balance sheet of more than 10 trillion dollars. To mitigate this major systemic risk, the United States adopted resolution rules applicable to these eight banking groups. These rules protect taxpayers from losses in the event of the failure of one of these banks (that is, if the higher capitalisation levels described above prove insufficient to avoid a failure). These mechanisms are also designed to reduce risk contagion among banks should one of them fail. So far they have not been put to trial by fire.

Loans to households: car and student loans are at risk

The post-Lehman economic recovery has seen a drastic reduction in household debt helped by the explosion of mortgage defaults in the subprime segment. Defaults on outstanding consumer loans have also risen to high levels. Household debt as a percentage of available income reached a record low of 135% in September 2013 after a peak of 110% at the end of 2007. The pace of growth of household debt has been relatively slow since. Should we conclude US banks and households have adopted virtuous conduct and that we shouldn't be overly concerned about them? The devil is definitely in the details. Although the risks remain relatively low in mortgage lending, the situation is more acute for student and car loans.

  • The increase in outstanding mortgages has in fact been limited in recent years as a result of lending conditions that are tighter now than during the pre-Lehman period. Total sub-prime loans (loans granted to customers whose creditworthiness is poor) as a percentage of total loan origination remains minimal. We also note a gradual improvement in the financial position of households with the sustained labour market recovery and the rebound in financial and real estate wealth. The percentage of households in negative equity has dropped sharply.
  • Meanwhile, the risks associated with outstanding consumer loans, which have increased 30% in five years, are clearly higher. Non-mortgage debt represents a growing proportion of total household debt (33% vs. 27% in 2008). This is due almost exclusively to the boom in car and student loans. Lending also fuelled the brisk dynamic growth of the US automotive sector: 2015 car sales reached an unprecedented 17.5 million units. As a repercussion of this growth, car and student loan arrears have been increasing. This trend needs to be monitored closely.

Loans to businesses: the Achilles heel of the US economy

Unlike households, the debt level of US businesses has grown sharply, reaching a 10-year high in late 2015. US companies have benefited greatly from the Fed’s ultra-accommodative monetary policy. Companies have raised record amounts of cash on the financial markets and from banks, mainly to finance M&As and asset buybacks, to the detriment of investment (See Cross Asset Investment Strategy - December 2015 “The huge increase of US corporate debt makes the Fed’s game more complicated”). Given the current high level of corporate debt, lower profits could do great harm if they trigger an increase in the number of defaults. Profit growth is a source of concern:

  • It is extremely important to understand that the profit growth witnessed in recent years has been the fruit of higher margins much more than growth in revenues. Despite the length of the expansion cycle, the recovery has turned out to be the softest in post-war history, which has resulted in relatively weak growth in earnings for businesses. Margins have increased due to significant contraction in production costs and, most importantly, a very limited rise in wages. Today, the potential for profits increasing via a rise in margins is extremely reduced: (1) margins are at historically high levels, and (2) the strength of the job market in the United States argues for a rise wages.
  • Corporate earnings in the manufacturing sector are already coming under heavy pressure. Within this broader context of US recovery, there is a clear discrepancy between the manufacturing and non-manufacturing sectors. Declines in oil and commodity prices continue to take a heavy toll on the US manufacturing industry. The ISM Manufacturing Index fell from 50.1 to 48.6, its lowest level since June 2009.
  • Our worst fears were confirmed by the energy sector, severely affected by the falling price of oil. Defaults are multiplying in this sector.

The direct effects are not necessarily the most worrisome. In and of themselves, the difficulties in the energy sector should not do much damage to the balance sheets of the big banks. The second-round effects are more worrisome even if they are difficult to assess. For instance, the weakness of US states that depend on oil could affect the quality of consumer, real estate or commercial loan portfolios. Lower personal income could translate into growing challenge for households to repay auto loans. We could then face a third-round effect: deterioration of bank balance sheets due to tighter financing conditions across the entire economy. High corporate debt in the US may grease the wheels for a domino effect.

Conclusion

The US economy is being hurt by the energy sector and, more broadly, by the manufacturing sector (20% of GDP). One vector for the transmission to the economy as a whole could be across the board tightening of financing conditions. But this trend, if it materialises at all, will take time.

 

 

 

 

 

 

 

 

 

 

 

 

The low interest rate environment is a drain
on the profitability of lending activities

 

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US corporate debt ratios have grown considerably since 2012, reaching their highest levels in a decade

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Cross Asset of March 2016 in English

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AINOUZ Valentine , CFA, Credit Strategy
HERNDL Stéphane , Credit Analysis at Amundi
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Loans to businesses: the Achilles heel of the US economy
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