Talking Banks - With Joe Fenech & Kevin Swanson Issue 3

“Bull markets are born on pessimism…” Technically speaking, the bear market in bank stocks ended in May 2023. Since then, bank stocks have increased by 33%, nearly matching the rise in the S&P 500. But it hasn’t felt like a new bull market is underway, with the index still nearly 40% below its post-pandemic high. Investors have been rattled by the near-collapse of another regional bank, a “higher for longer” rate environment that’s extended the tail of margin pressure, and fears of commercial real estate Armageddon. So while the bear market may be behind us, the sector’s malaise persists, forestalling a more durable rally in bank stock prices.

What will it take and what’s the catalyst? We’d argue that the kindling is already set and just awaits a spark. Bank valuations sit near multi-decade lows, especially on a relative basis, reflecting the sour sentiment accumulated during the long bear market rather than the brighter outlook we foresee just ahead. And stocks don’t move higher just because they’re cheap, while lingering challenges aren’t easily dismissed. Valuation is in effect like kindling exposed after a storm, with rain clouds still visible; it’s there but it’s difficult finding a spark in such conditions. So what are the storm clouds, when will they dissipate, and what’s the spark that will ignite this new bank stock investment cycle?

Balance sheets needed to fully adjust to higher rates, and we’re just about there. This process has taken longer than expected, as the Fed pivot telegraphed late last year has been slow to materialize. Expectations for up to six Fed rate cuts at the start of this year have been dialed back to one, and maybe even zero. While more rate cuts would help, this balance sheet adjustment process is in its final stages and isn’t reliant on an accommodative Fed.

Bank balance sheets were constructed during a period of record-low rates from ‘08 to early ‘22, when the Fed began to raise rates and flipped to QT from QE. Unlike pre-‘08, a complete failure of risk management by the industry, balance sheets were not built irresponsibly post-‘08. As a research analyst in mid-‘16, I remember a portfolio manager at one of the biggest fund managers in the world lambasting bank management on a roadshow for not having the capability to model for negative rates, because according to this PM that was where we were headed. It’s easy today to forget the rationale for decisions made in a different era.

The point is that after an unprecedented rate hike cycle, it takes time for balance sheets to adjust. Pre-‘08, banks operated profitably for decades in comparable rate environments and traded at much higher valuations. So it’s not the absolute level of current rates that’s the problem, it’s the rapidity of the required adjustment for developments that no one could have reasonably foreseen. But this rate environment over time, absent the yield curve inversion, should prove more beneficial for margins and bank stock valuations than when rates were near-zero.

So where are we in the adjustment process? Deposit beta is a widely watched metric that measures the responsiveness of deposit costs to changes in short-term interest rates. From the chart below, deposit betas are similar across the industry cycle-to-date, at about 40%. Less attention is focused on the asset side, where larger banks’ asset yields have been much more responsive, more than double the loan beta at smaller banks! This makes sense, as larger banks have more variable rate loans, less longer-term fixed rate loans and tend to be more sophisticated in managing their investment portfolio.

It’s no surprise then why the big banks, like JP Morgan, have continually raised guidance through this cycle and have seen valuation normalize at a much quicker pace (despite the $1 trillion+ asset group valuation weighed down by Citigroup trading at 70% TBV). Interestingly, valuations are highly correlated to these metrics; where asset repricing has lagged, banks trade at much lower valuations. This analysis doesn’t entirely explain the valuation gap between large and small, but it arguably does more so than any other single metric.

Interest Rate Beta

Source: S&P Global; Data as of 6/28/24

The takeaway is that this headwind will soon flip to a significant tailwind, for virtually all banks. Most banks will still see deposit pricing pressure over the rest of this year, particularly while QT remains in place (though QT slowed dramatically beginning in June). But if the Fed is done raising rates, funding pressure is mostly behind us. On the flip side, the upward repricing of longer-term fixed rate assets is still to come, which should provide a multi-year tailwind to margins beginning in 2025.

Fed Balance SheetSource: S&P Global; Data as of 7/3/24

Consider this commentary from a regional bank we respect very much, SouthState Corp. (SSB): “We have about $10 bil. of floating rate loans. And if we get 6 rate cuts, that will cost us $150 mil. We also have a $37 bil. deposit portfolio, we’re modeling a 20% down beta (33% on the way up; 20% on the way down). That would help us by $110 mil. or so. The thing left that really propels everything is the $8 bil of fixed rate assets that reprices upward in the 2%-3% range. At 2%, that’s $160 mil. So you lose $150 mil. on the floating, you gain $110 mil. on the deposits and then you gain another $160 mil. on the fixed rate repricing. That’s $120 mil. or so on a run rate of $40 bil., (equating to) about a 30 bps improvement (to NIM).”

Another mid-sized bank, Synovus Financial Corp. (SNV) had this to say: “When you think longer-term about our NIM, first, we have headwinds on the liability side, we clearly saw those in Q1. We expect those to be mitigated in Q2 as we see stabilization in both rate and mix. Then you look at the margin and the multiyear benefit of the fixed rate asset repricing, if you’re assuming rates stay stable. When I look at Q4 of this year, and I compare it to Q4 of ’25, there is about a 20 bps benefit (to NIM) due to fixed rate asset repricing.”

Now, the CEO of Fifth Third Bancorp (FITB) articulates well the risk to this thesis, which we think partly explains the continued overhang on bank stock valuations: “We view current fiscal and monetary policy to be at odds and that the fiscal side is unsustainable and inflationary over time. And the longer it goes on, the more the Fed will need to remain higher for longer, which puts pressure on the long end of the curve. And we know that the longer rates stay elevated, the more likely it is that you see adverse consequences either in asset prices or in credit performance.”

In considering this warning, we’re reminded of the Mike Tyson saying that “everyone has a plan until they get punched in the mouth”. Embedded in this thesis on the coming favorable tailwind to bank margins is a couple of key assumptions, most notably that rates remain relatively stable (or move lower) and asset quality mostly holds. Which brings us to the other main storm cloud currently overhanging bank stocks.

While there’s no denying that CRE is a significant risk, it remains a very manageable concern. High-profile, CRE-related stumbles like New York Community Bancorp (NYCB) haven’t helped the perception (in the press and amongst investors) of commercial real estate as some sort of ticking time bomb on bank balance sheets. Our belief is that NYCB’s credit problems in rent-regulated apartments and tall office towers in New York City shouldn’t serve as an indictment of the industry’s $3.6 trillion of multifamily, industrial, retail, and office CRE exposure. But this perception will reign until conclusively disproven.

That said, there have been several developments that in our view continue to refute the notion that CRE concentration in and of itself should be construed as a proxy for risk.

• Price discovery is happening: Recent sale highlights value and liquidity. In late June, Washington Federal Bank (WAFD), a company and leadership team we’ve known and admired for over two decades, sold $2.8 bil. of multifamily CRE loans to Bank of America, which in turn sold to PIMCO, representing the largest CRE loan sale ever. Executed at 92% of principal, the discount was almost entirely attributable to changes in rates, rather than credit. CEO Brent Beardall gave an insightful CNBC interview on why he believes CRE concerns are overblown (Link to Article). The loans sold in this transaction are far more representative of the credit on small bank balance sheets than what NYCB stumbled on earlier this year.
• More evidence supporting our view that the rescue of NYCB was the inflection point of this cycle. In the prior cycle, while the stocks bottomed in March 2009, it was the capital injection in BankUnited, led by John Kanas and other investors that set the stage for the recapitalization of the sector. We think a similar series of events is playing out in this cycle (absent the need for a complete sector recapitalization this time). While the bear market ended in May 2023, we think the true cycle inflection point is the rescue of NYCB by the PE group led by Steve Mnuchin in March 2024.
• We continue to believe that if the $1 bil. capital injection into the sector’s biggest problem child is sufficient, then it will be very difficult to argue that CRE exposure isn’t manageable for the industry. Management has since completed a deep dive of the portfolio, and Q1 results yielded no bombshell developments. So absent a larger issue emerging at a larger-sized regional bank, which is hard to envision, and if $1 bil. in capital proves sufficient to solve the sector’s biggest problem, how is this event not the turning point?
• Even in office, the problem is effectively ring-fenced. There isn’t a pure, data-driven approach to properly assess summary statistics on the sector’s office exposure. Some banks don’t break it out, others don’t disclose specific reserves against office loans, and even when disclosed, it’s difficult to ascertain aspects of risk, such as suburban vs. metro exposure. But there are important things we do know. For instance, small banks have clearly slow-walked the reserve build that will be required to deal with the problem, fearful of potentially spooking the market with large provisions that will hurt earnings and call into question the sustainability of the dividend.
  

But the largest banks have the wherewithal and the incentive to put this problem behind them as soon as possible. The earnings profile for this group is much stronger, and they’re much less exposed to commercial real estate, though they have more of the “bad stuff”, not due to poor underwriting, but just because it’s the big banks (and non-banks) that lend on office towers in major metros that have been most impacted by post-COVID workplace trends. So not to be cynical about it, but for these reasons, larger banks in our view are more apt to be truth-tellers on office exposure through aggressive reserve build, rather than drag out the process.

Take, for instance, Wells Fargo (WFC): Management has now for two consecutive quarters said publicly that the current level of reserves against its office book (~11%) is sufficient to deal with the problem. Looking at other larger banks, US Bancorp (USB) has about a 10% reserve, Truist (TFC) is just over 9%, JP Morgan (JPM) is at 8%, and Citizens Financial (CFG) is just under 11%. While CFG hasn’t said definitively that reserve build is behind them, the 10.6% office reserve assumes a 71% decline in property values, and coupled with incurred losses to-date of 6% implies cycle losses of ~17%, with losses peaking later this year or early next. So if the largest banks are correct, and ~10% reserves prove sufficient to deal with the worst of this CRE exposure, then not only is the problem manageable, but the earnings hit is already behind these companies as well!

Now, if these numbers are correct, many small community banks on the surface are woefully under-reserved, the perception of which is likely why most of them don’t disclose office-specific reserves. But when assessing the magnitude of the problem, consider that (1) small banks, even in the aggregate, can’t drive a systemic credit event; (2) small banks typically don’t lend on the types of properties that are necessitating the large reserves at the big banks.

On this point, the Federal Reserve Bank of Kansas City recently published data (Link to Article) noting that office properties with 500,000+ square feet have a 22% probability of default versus 5% for buildings with < 150,000 square feet. Smaller banks, with average loan sizes in the low seven figures, are likely to be lending on these smaller-sized buildings. Also, per research from Stephens Inc., the FDIC Quarterly Banking Profile showed that larger banks had significantly worse CRE-related credit quality metrics than small banks. Non-owner occupied CRE at the largest banks ($250 bil+ assets) had a past due and nonaccrual ratio of 4.48%, more than double smaller banks ($10 bil. to $250 bil. in assets), at 1.47%, and 6x higher than very small banks ($1 bil. to $10 bil.), at 0.69%. Again, this isn’t due to poor underwriting, but rather that it's the large banks that lend on the properties that are most challenged. Slowly but surely, the press is coming around on this topic (Link to Article) and eventually, the market will as well.

Comments from Wells Fargo’s CFO at a recent investor conference really in our view sum up the issue very well: “Most of the (CRE) portfolio is performing pretty well. Multifamily is the biggest piece, a little over $40 bil., very low delinquencies, almost nil. As you go down the rest of the (CRE) asset classes, it’s a similar theme. Data centers, logistics, industrial, even our hotel and retail portfolios are doing well overall. In office, you have to break it into a couple of chunks. The first is what we see primarily in our commercial bank, which are smaller office buildings, many have recourse, are owner occupied and those are performing well, most are smaller-sized loans. The issue is really institutional office space, and it’s a wide range of outcomes. Some office buildings are doing really well. You go to Hudson Yards in NYC, they’re going really well. You go to Times Square in NYC, not doing as well. Older office buildings that are not renovated in certain areas of different cities are the places you’re seeing the most stress. And we’ve had some charge-offs. We have an 11% coverage ratio against that part of the portfolio, so we feel like we’re appropriately reserved for a range of outcomes there, and it’s going to take some time to play out.”

• Smart acquirers seem more opportunistic than fearful. In late May, SouthState Corp. (SSB) announced plans to acquire Texas-based Independent Bank Group (IBTX). The deal is germane to the CRE discussion for a few reasons (and for other reasons more broadly that we’ll detail in a later issue).
  • CRE represents 57% of total loans at IBTX. While the target is a strong underwriter, it’s difficult to believe that one of the sector’s most highly regarded operators and savvy acquirers would look to acquire a CRE-heavy bank ahead of a potential CRE-driven apocalypse. 
  • The mark against the target’s office book is in the upper single digit percentage range, slightly below the largest banks, which makes sense as IBTX is a small bank with less exposure to major metro areas. In an acquisition scenario, the acquirer has every incentive to mark the target’s book conservatively. So big banks and conservative acquirers are telling us this is the right number, so…maybe it’s the right number? If so, it’s very manageable.
  • On CRE more broadly, SSB management noted that the South is benefiting disproportionately from in-migration, as evidenced by rental rate trends on all types of CRE. In the last 3 years, rental rates on office, multifamily, and industrial property in SSB’s markets are up 16%, 21%, and 38%, compared to 3%, 14%, and 24%, outside their markets.

Visibility to the first rate cut is the likely stock catalyst. Dispelling the negatives helps to set the stage for better times ahead, but it’s not a reliable accelerant for the stocks. If we look back to late last year, bank stocks increased by over 30% on talk of the Fed pivot. Expectations for six Fed rate cuts in 2024 quickly took hold but was then quickly followed by an unfortunate series of events, including the implosion of NYCB and renewed CRE fears, a few unfavorable inflation readings, and a significant back-up in interest rates. Rate cut expectations were significantly dialed back, the inflection point in industry margins was pushed further out, and credit concerns moved to the forefront, prompting more of a “wait and see” approach, leaving the stocks volatile but ultimately directionless through the first half of this year.

Looking to Europe, the rate hike cycle was less aggressive in pace and magnitude than in the U.S., ultimately affording ECB officials greater flexibility to articulate and deliver on a timeline for rate reductions that aligned with market expectations (Link to Article). The iShares MSCI Europe Financials ETF (EUFN) is up 9% on the year (and that’s following a recent pullback) and up 62% since late 2022.  U.S. bank stocks were on that same initial trajectory, but have since languished due to lack of clarity, down now about 8% on the year, and down 24% since late 2022.  The bottom line is that we see the situation in the U.S. generally following the recovery trend we’ve seen to date in Europe, as visibility to that first rate cut in the U.S. comes into sharper focus.

EUFN vs KRE

Source: S&P Global; Data as of 7/8/24

The negative spread between the 2 / 5 year, and 2 / 10 year Treasuries has narrowed, fluctuating recently between 30 and 40 bps. So visibility to even just one 25 bps rate cut, all other things equal, would effectively flatten the yield curve, eliminating arguably the most consistent overhang on bank stocks during this cycle. Of course, rates don’t move in a vacuum and so the driver of rate movements matters as well, with the soft-landing scenario that includes a reasonably strong economy and continued progress on inflation as the preferred outcome.

The inflection point in net interest margin for the industry should then draw generalist investors back to the bank sector for the first time since margins began to come under increasing pressure in the near-zero rate environment post the 2008 financial crisis. Also, pent-up M&A demand should unleash a consolidation wave that historically has proven beneficial to bank stock prices.

Disclosures: Of the individual stocks mentioned, our investment fund currently has long positions in Wells Fargo & Co. (WFC), Bank of America Corp. (BAC), Citigroup Inc. (C), Truist Financial Corp (TFC), Independent Bank Group Inc (IBTX), and preferred stock in New York Community Bancorp, Inc (NYCB), Synovus Financial Corp. (SNV), and WaFd Inc. (WAFD). Our investment fund currently has a short position in Synovus Financial Corp. (SNV). The authors have long-standing long positions in Citigroup Inc., and JPMorgan Chase & Co. in their personal investment accounts, an investment that pre-dates the launch of our investment fund.

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