Nobody's Talking About the Banks
Will it stay that way?
|Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.|
A Quiet Place
In the single month of October 2008, Wachovia Bank, Royal Bank of Scotland, Lloyds of London, UBS, and National City Bank vanished, being either seized by their governments or acquired at fire-sale prices by their competitors. Bank failures were the economic story of autumn 2008--which is why that year’s stock bear market is widely known as the “global financial crisis.”
Not so much in 2020. The COVID-19 crisis has elicited much discussion about widespread unemployment, gyrating stock prices, and grim prospects for companies that depend upon travel (along with bright forecasts for firms that deliver their goods or services to households). Absent from the news have been the banks. Thus far, they have steered clear of the headlines.
Of course, these are early days. Even poorly capitalized banks can withstand some delinquencies. It would be an ill omen if rumors were already circulating about the quality of their loan portfolios, with the U.S. economic slowdown in merely its second month. Still, the absence of bad news is a blessing by omission.
Down, Not Out
Not, to be sure, that the prognosis is entirely favorable. More than half the loans of America’s four largest banks--(JPMorgan Chase), (Bank of America), (Citigroup), and (Wells Fargo)--are either to businesses or for residential mortgages. Many of the former will soon default, because companies that are shuttered will likely defer their bills. Mortgages, perhaps, will perform better, thanks to the CARES Act’s enhanced unemployment benefits, but they surely face their own problems.
For this reason, those four banks stashed away $23 billion in loan-loss reserves during first-quarter 2020. As that amount represents less than 1% of their aggregate loan portfolios, those provisions are but a beginning. For the foreseeable future, expect such announcements at the end of each fiscal quarter.
Bank stocks, predictably, have been whacked. Morningstar’s Diversified U.S. Banks Index has dropped 35% for the year to date, as opposed to a mere 11% for the S&P 500 (the recent rally has been powerful indeed). Fortunately, says Morningstar banking analyst Eric Compton, investor concern is profitability, not survival. “The losses the banks booked were manageable. If they have several more quarters of that, they will be fine.”
Those who invest in credit default swaps on the debt issued by bonds would appear to agree with Compton. Those swaps are trading near their late-February levels, which indicates that professional investors aren’t terribly worried about bankruptcies from the major U.S. banks. (There is greater concern with some of the European banks.)
One big reason for their relative optimism is the Federal Reserve’s aggressiveness. To be sure, the Fed was active throughout 2008, attempting to forestall emergencies before they occurred, rather than react after the fact. However, it approached the troubles gradually, with a $50 billion bailout here, an interest-rate cut there. Consequently, its measures were often insufficient.
This year, in contrast, the Federal Reserve has acted with alacrity. The stock market first signaled its economic concerns during the final week of February. By mid-March, the Fed had cut short-term interest rates to zero; began to purchase commercial paper and municipal debt, while shoring up money market funds; and removed the limits from its scheduled asset-purchase program. No longer would that program stop at $700 billion; instead, the Fed would buy assets “in the amount needed to support smooth market functioning.”
Following several additional edicts, the Fed on April 9 announced an additional $2.3 trillion operation that would provide liquidity to banks that issue small-business loans under the CARES Act. The program would also support the high-yield market by purchasing bonds that have been downgraded, and it sets aside $500 billion to buy debt from state and local governments. The Fed has been busy!
In addition, banks entered 2020 better capitalized than in the past. According to data compiled by the Federal Reserve Bank of St. Louis, banks entered the millennium holding an average of 8.5% in capital to cover their assets. Today, that figure stands at 11.7%. Better yet, the ratio of tangible capital to tangible assets, which is a more rigorous standard, has increased from 4.7% entering the 2008 financial crisis to 7.6% in December 2020.
Banks’ ability to withstand financial shocks has likely been strengthened by a provision in the 2010 Dodd-Frank Act that mandates that “stress tests”--which simulate how bank balance sheets respond to bad news--be conducted by government regulators. Previously, banks were permitted to self-administer such evaluations, which led, shall we say, to a certain amount of grade inflation. (If you ask students to grade their own papers, the task will be done enthusiastically, but not always rigorously.)
None of this is offered as a prediction. The enormous uncertainty about when and how the global economy can resume something approaching normalcy overwhelms the analysis. The current economic consensus forecasts a huge gross domestic product drop in second-quarter 2020, followed by a smaller decline in the third quarter, and then a recovery in the fourth. Banks would have no problem withstanding that scenario, particularly with the Federal Reserve’s aggressive assistance.
However, that economic consensus embeds crucial assumptions about the spread of COVID-19, the effectiveness of countermeasures, and political decisions about social distancing that are, at heart, conjectures. Economists do not possess healthcare information that epidemiologists do not, nor can they do more than guess at how the current political debates will settle.
In summary, there is cause for guarded optimism. Banks entered 2020 well capitalized and with relatively healthy loan portfolios, thereby positioning themselves to resist severe economic damage. Whether they can weather a catastrophe is another matter. We shall fervently hope that they are not put to that test.
A friend emails me that he switched 401(k) providers, after changing jobs. Rather than electronically transfer the funds, his 401(k) recordkeeper cut a check and dropped it into the mail, thereby keeping him out of the stock market during the last week of March, when the S&P 500 gained 14%. Talk about a high transaction cost!
On the flip side, I recently read this confession. “It was so complicated to change my 401(k) that I didn’t get around to establishing a new plan for an entire year. My account just sat in cash.” That year was... 2008. Well done, sir, well done.
Note: Shortly after I filed this column, Bloomberg’s Matt Levine published the following: “My general impression of the role of banks in the current financial crisis is that the response to the last financial crisis worked pretty well. In 2008, banks were at the center of the trouble in the economy, and the regulatory response was to make them far better capitalized, less exposed to market risk, and generally more responsible. In 2020, banks are not the cause of the trouble, and the fact that they were well capitalized and responsible going into the crisis has made it possible for them to be part of the solution. They can lend and offer forbearance on loans and waive covenants and intermediate trades and generally be supportive of their customers because they have reasonable amounts of capital, and because the market has a reasonable amount of trust in them. Also because of massive Fed programs, to be clear; this is not a story of purely private-sector bankers coming together to save the world. Still the basic public/private partnership of bank and regulatory responses to the last crisis seems to have held up pretty well in this one.”
Editor’s Note: This version of the article has been updated to reflect that on April 9 the Fed announced an additional $2.3 trillion operation, rather than $2.3 billion.
John Rekenthaler (firstname.lastname@example.org) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.