Via Goldman Sachs: We are in the third period of a loosening of bank underwriting standards in the past two decades. The outcomes of the first (1993-1998) and second (2004-2007) were materially different, as the former resulted in an acceleration in loan growth (9% per year) with minor implications for credit losses, while the latter contributed to the financial crisis. Lower leverage, new regulations (particularly capital) and limited demand could make this time different.
Banks To Continue To Loosen Expected In Third Period
In fact, without a return in demand, we expect banks to continue to loosen via duration extension and moving further into risky lending areas. Given the significant pick-up in comments around loosening of underwriting standards, we take a deep dive into the topic and look at the implications in three key lending markets (1) C&I (including syndicated/leveraged lending), (2) commercial real estate and (3) auto. Key observations from past cycles:
- Loan growth accelerates (+): While loan balances have advanced just 2% during the current loosening cycle, past cycles yielded average growth in the 8-10% range (see page 6), implying an acceleration from here could be on its way. That said, (1) changes in regulation, (2) new capital standards, (3) continued run-off portfolios and 4) low levels of demand due to high cash balances at corporates could prevent us from seeing growth move back to those levels.
- Spread compression increases (-): Loans are similar to other products – if you make them less expensive, more will be consumed. Cycle to date, C&I spreads are down 90bps from the peak to 3.5% vs. 130bps of compression in the 1990s and 250bps in the 2000s), implying they could compress an additional 60-90bps. While large corporate has seen the most compression thus far, middle market and small businesses appear poised for further compression (see page 9). Without higher demand, the growth vs. spread compression trade-off might not manifest itself, leading to riskier lending.
- Structures weaken as terms extend, collateral lessens and lenders “move down market” (-): If an acceleration of loan growth does not materialize, we expect banks to (1) further extend durations (some are offering 96-month auto loans, 10-year fixed rate C&I loans are becoming more popular) and (2) engage further in riskier lending, including syndicated and leveraged lending (see pages 17-20) and subprime auto.
The biggest risks, in our view, are that (1) credit eventually could turn and (2) asset sensitivity could be reduced. In the prior two cycles, charge-offs began to rise (or at least stabilized) three years after the beginning of the loosening cycle. However, given how severe the credit cycle was in the last crisis, we think a rise in credit losses in the near term is unlikely. That said, if higher credit losses do materialize, this could be a risk to market expectations, in our view. In terms of asset sensitivity, some banks are offering 10-year fixed rate loans. Once rates rise, we estimate banks making these loans will go from earning their cost of capital (10% ROE) to 0%, in addition to reduced asset sensitivity. That said, this could take multiple years to show up in the data.
What does this mean for the stocks? While spread compression will show up, higher losses can take long periods of time to show up (see the 2003-2007 cycle). Therefore, outside of credit issues, any bank’s ability to outgrow its peers could be a significant driver of share price outperformance. Our analysis suggests owning risk seekers (FITB, RF and STI) and growth at a price at this point in the cycle. Below we divided the group into four categories, which we believe could drive share performance:
- Risk seekers: these loosen standards for greater than peer growth. Margin pressure remains lower due to term extensions, moving down the credit spectrum or lower collateral requirements. Own these stocks during the loosening period. Fifth Third Bancorp (NASDAQ:FITB), PNC Financial Services (NYSE:PNC), Regions Financial Corporation (NYSE:RF) and SunTrust Banks, Inc. (NYSE:STI) screen in this bucket.
- Growth at a price: these loosen standards and are willing to trade growth for a lower spread. Margin pressure is high as loosening is most likely limited to price concessions. These stocks tend to outperform to a lesser extent. Bank of America Corp (NYSE:BAC), Capital One Financial Corp. (NYSE:COF), City National Corp (NYSE:CYN), First Niagara Financial Group Inc. (NASDAQ:FNFG), JPMorgan Chase & Co. (NYSE:JPM), KeyCorp (NYSE:KEY), Synovus Financial Corp. (NYSE:SNV) and Wells Fargo & Co (NYSE:WFC) screen in here. ? Margin preservers: Maintaining spread tends to drive these away from deals, leading to lower growth. Spreads usually move with industry. These stocks tend to underperform slightly, but are usually strong performers “through the cycle.” Comerica Incorporated (NYSE:CMA), Huntington Bancshares Incorporated (NASDAQ:HBAN), M&T Bank Corporation (NYSE:MTB) and Zions Bancorporation (NASDAQ:ZION) fit this category.
- Risk averters: Prudent discipline drives lower growth and less chasing of yield/higher margins. Shares underperform during credit loosening period. First Horizon National Corporation (NYSE:FHN), BB&T Corporation (NYSE:BBT) and U.S. Bancorp (NYSE:USB) fit this category.