Asset Based Lending
Chief Investment Officer
Commercial Loan Automation
BirdsEye Viewmidyear review
Second quarter earnings are trickling in, but the trend is already evident: things appear to be getting better. Most early-reporting banks beat expectations and show improving asset quality metrics.
Once you dig in a bit, though, the picture changes dramatically and isn’t nearly as rosy. Revenue and loan growth are minimal to negative, and the main driver behind the improved numbers are, in effect, loan loss provision reversals. Sharp cuts in allowance for loan losses (ALLL) account for most, in some cases more than 100%, of the earnings gains. At the same time, non performing loans and charge-offs, while declining, have not improved at a similar rate. ALLL rarely kept pace even with charge-offs, which confirms the statement that reserve releases are the main driver behind the 2Q earnings beat.
Further, looking at Pre-Tax-Pre-Provision (PPTP) earnings yields barely a change, both sequentially and year over year. The sweeping trend of funding earnings by ALLL is of concern, given the lackluster economic environment. Provision reductions seem awfully early kin the cycle… At minimum, I’d like to see provisions cover charge-offs to keep ALLL intact, but 2Q10 earnings certainly were not achieved by and large with this rule in mind.
PTPP and other key bank operating fundamentals are likely to remain sluggish for some time, reflecting an economy that’s moving sideways with minimal progress in the coming year. Our banker forums consensus is that it’ll be 2012 before we see meaningful improvement. Loan demand is practically non-existent, while cash keeps flowing into the banks with nowhere to invest it.
We all know that core deposits are essential for bank valuations, profitability, earnings consistency and capital availability. We also know that whenever we strayed meaningfully from core funding, eventually the price paid for risky leverage was huge, often terminal. Yet carrying core deposits in this unprecedented low rate environment is very costly. How can banks keep on garnering deposit share, albeit possibly a temporary one, for long term gain while bleeding short term earnings and negative spreads?
This short-term quandary is greatly exacerbated by the regulatory posture and overzealousness,
and the uncertainty embedded in the Dodd-Frank bill.
First, regulatory posture has gone from being too permissive to overly harsh. Some examiners are harshly reclassifying stressed but often fully performing loans, causing reserves to shoot up and swallowing precious capital. At the same time, in-effect MINIMUM capital ratios have been raised to 6% tangible common, 8% regulatory and 12% risk based. In reality, 9% and 14% are more common, given the unpredictable reclassification shocks. As a result, banks resort to distressed asset sales, eliminating the possibility of fully recovering asset values and forcing further hits to capital while further depressing the markets by flooding them with inventory.
This development, which causes balance sheet shrinkage and negative market implications, is particularly ironic as regulators pressure banks to lend into the non-existent loan demand environment while, at the same time, they cause major capital hits to their very same balance sheets in a more threatening landscape which they themselves created.
The newly enacted Dodd-Frank bill injected another layer of uncertainty into banks’ operating environment. The bill and its interpretation will take months to decipher, and are certain to have major impacts on the industry. The results: gun-shy bankers and investors who are reluctant to take any risk or action, given fears that the rules might change mid-stream as they take major strategic initiatives. And how can you blame them, considering the most recent bait-and-switch tactics we witnessed with TARP?
Is hunkering down the answer? I think not.
Banks whose balance sheets are still comprised of too much foo-foo (“pretend” core funding such as high yield MMAs; large loans, especially relative to their asset size and capital base; industry and borrower concentrations; lots of wholesale funding of every sort) can focus on clearing out the debris from their balance sheet and refocusing on value creation.
Those banks who already enjoy “fortress balance sheets” and strong management teams should capitalize upon battle fatigue among their brethren and gain market share by reasonably-priced acquisitions, effective marketing campaigns and old-fashioned effective execution. Another non-negotiable is a strong compliance program and a healthy relationship with the regulators.
I expect some stirrings in M&A activity, and we already know an unprecedented 2/3rds of commercial customers are open to discuss banking relationships with other banks. This is a time of opportunity; take advantage of it.