US Banks largely ‘out of the woods’

It has been four years since the near collapse, rescue and then struggling recovery of US banks. Over this period, the banking system has clearly not operated as normal and this has been an impediment to a robust economic recovery in the US.

Today, we see that banks are making loans at a relatively healthy pace, they are reasonably well capitalized, their funding mix is more stable than it has been in years and they continue to receive large deposit inflows. Surveys of banks indicate that they are willing to make loans if the credit quality is reasonable.

US banks appear to be by-and-large out of the woods and operating in a near-normal fashion, with the biggest lingering risk being contagion and counter-party risk from European banks.

Related to these risks, banks continue to pay down wholesale funding, which is highly abnormal because banks tend to leverage up through these channels in order to expand their balance sheets more aggressively. The ongoing strains in credit markets are likely to constrain banks’ ability to leverage up beyond their core deposit growth.

Taking a few steps back, it looks as if, with the exception of the small segment of European-owned banks operating in the US, banks are mostly ready to play a part in the credit cycle that is close to normal. However, because the rest of the financial system continues to de-leverage and because the ultimate borrowers remain over-indebted and continue to de-leverage, overall credit creation remains constrained.

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Looking at these issues in more detail, in recent months, data show that banks have moved from de-leveraging to making new loans at a moderately healthy pace. While the pace of loan creation is lower than during the bubble period, it has been relatively healthy. As for the types of loans that banks are making, three out of four of the major types of loans are now growing: residential mortgage loans, commerce and industry (C&I) loans and consumer credit loans. Banks continue to de-leverage in commercial real estate loans, although the pace of deleveraging has slowed a touch in recent months.

The past four years of minimal lending has allowed banks to direct funds raised via retail deposit flows into bonds. This has given them a more conservative asset mix with the highest portion of assets in Treasuries and Agencies in over a decade.

Banks remain well capitalized and continue to raise capital primarily through retained earnings. Indeed, banks are generally adequately capitalized to handle substantial losses and the implementation of Basel III, although they remain vulnerable to a severe economic downturn. Given Bank of America’s ongoing legacy loan loss exposures and projections for earnings and losses, there is more uncertainty in this particular case, but our best guess is that it is the only large bank that needs to raise a more significant amount of capital. We can estimate that in aggregate US banks will need to raise $35bn in capital, of which $25bn is due to Bank of America.

In recent years, banks have been shifting their funding from relying on riskier sources of hot money like large time deposits, repo and commercial paper to relying on core retail deposits. As a result, banks’ funding mix is more conservative today than it has been in years.

Banks continue to receive large core deposit inflows, so they have been able to continue paying down short-term borrowings as well as make new loans at the same time. However, it is important to note that it is highly unusual for banks to pay down bonds and wholesale funding while leveraging up their balance sheet, since normally banks choose to borrow through these channels in order to leverage up their balance sheets more aggressively than would be possible only through deposit growth. The ongoing strains in credit markets are likely to constrain banks’ ability to leverage up beyond their core deposit growth. CDS on bank bonds is pricing in about as much risk as in 2008 and 2009, and the LIBOR spread remains elevated although it is well below peak crisis levels.

There is a small segment of foreign-owned banks in the US, which are under tremendous pressure to de-leverage due to tightness in US dollar funding. Foreign banks are generally not a major part of the US credit creation picture, but their largest role is in the C&I loan market, where they hold about a quarter of outstanding loans. Many of these banks are European, and the top 3 French banks hold about $30bn in US C&I loans. These banks are starting to pull back due to the tightness of US$ liquidity. For example, SocGen announced that it will stop its funding of aircrafts, ships and LBOs in the US. Not surprisingly, these banks have tightened their credit standards in recent months as part of their broader moves to cut back on dollar lending, while domestic US banks are easing.

Adding up the pieces, U.S. banks appear to be by-and-large out of the woods and operating in a near normal fashion, and they are mostly ready to play a part in the credit cycle that is much closer to normal than over the past few years. Among borrowers, conditions have normalized most in the business sector, as borrowing by non-financial businesses is now about normal. The decline in business borrowing over the crisis period was concentrated in loans, as small businesses were squeezed and bigger businesses continued to issue long-term bonds in an attempt to move to longer-term and more secure sources of funding as banks pulled back. Corporate bond issuance remains strong, and the recent recovery has been driven by the banks, which have moved from deleveraging to making new loans to businesses.

In contrast, household borrowing remains extremely depressed, because households borrow primarily through the mortgage market and this credit pipe remains severely constrained. Banks have used their increasing loan capacity to step in, but this has largely just offset other parts of the financial sector to continue to deleverage. In particular, Fannie Mae and Freddie Mac are required by law to continue to de-leverage their own balance sheets, and while they can issue Agency MBS in order to replace this capacity, in practice commercial banks have often offset government sponsored enterprise (GSE) de-leveraging in periods when it has picked up. Other parts of the credit system, particularly remnants of the shadow banking system such as private label MBS and CMBS and SIVs, remain dead in the water. The pickup in bank lending has been able to help offset these forces to some degree.

Despite the banks’ increasing willingness to make mortgage loans, households remain severely over-indebted and need to continue to de-leverage, and simply there are not enough creditworthy borrowers for the banks to lend to. Nearly one in ten households is severely delinquent or in default. Additionally, over 30% of existing mortgages remain underwater, so current borrowers cannot increase their loans when they re-finance, if they are even eligible. And home prices are likely to remain depressed for a long time given the massive overhang of homes to be sold.

Given that banks have room to expand their balance sheets but have few eligible borrowers in the US, they have been gradually starting to pick up assets where European banks have pulled out. For example, so far this year, there have been 16 M&A deals worth a total of $18bn where a US bank bought a foreign owned banking asset, such as Capital One’s purchases of HSBC’s US credit business and ING’s US online bank. Additionally, there have been a string of deals where US banks have bought raw loans from European banks, such as Wells Fargo and JP Morgan’s purchases of about $11bn in US commercial real estate loans from Irish banks. In addition to European banks selling their existing assets, US banks are expanding their balance sheets by gradually taking business from foreign banks. Hershey made headlines recently when it renewed a credit line by removing a UK bank and replacing it with smaller domestic banks, and USBank also mentioned in its latest earnings call that it is winning new business from US companies that previously borrowed from foreign banks. This shift in market share is another example of US bank lending outpacing aggregate credit growth as other financial institutions deleverage.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla