1. The overall tone was more positive than I expected--particularly from the banks. Yes, the industry is back from the brink. But it still faces considerable uncertainty on credit, even as companies continue to rely on substantial support from the federal government. Given that, I expected some companies to be mostly optimistic and others cautious. That didn’t happen. Companies seemed to be universally upbeat. Even those banks that have been experiencing the greatest credit problems now feel they have their hands around the issues and are managing through them.
This is not to say that every institution says its problem assets have peaked. (They almost certainly have not.) But each one I heard cited positive lending indicators. With respect to consumer loans, for example, delinquencies are down even in the face of negative seasonal pressures. On the commercial side, downgrades and the inflow of new problem loans has slowed.
The presentations confirmed to me that credit expenses are near a peak. I expect that credit costs will remain high in this year’s third and fourth quarters, then fall sharply in 2010, 2011 and 2012 as earnings return to “normal.” In the meantime, many investors and analysts are severely underestimating how fast credit expenses will fall as the economy recovers. These people will be skeptical, initially, when provision expenses fall below net charge-offs. It happens every cycle.
2. Investors are too pessimistic regarding coming losses in commercial real estate. Based on questions they asked, investors seem to feel that cumulative loss rates in commercial real estate lending will eventually match loss rates in residential construction lending. I doubt that will happen.
This CRE cycle differs from the last major down cycle, which occurred in the late 1980s, in three important ways. First, excess inventory this time around is significantly lower in each product type (office, retail, and so on) than it was at the start of the last downturn. Second, underwriting standards have stayed more rigorous. In particular loan-to-value ratios tend to be lower and cash flow coverage stronger. Plus, in their underwriting, lenders have made extensive use of re-managing provisions and have conducted and stronger analysis of borrowers. Finally, the overall level of interest rates is much lower now, so borrowers can support cash-short projects longer.
Make no mistake about it, problems on the CRE side are just beginning. Reserves and charge-offs are certainly headed higher. But loss rates will be nothing like the hangover that occurred after the bubble in residential construction lending popped. I believe most investors are significantly overestimating the cumulative losses that will occur in CRE.
3. Government “stress test” loss estimates are way too high. I’ve said this ever since the test results were released back in tk. Now, two quarters into the eight quarters the tests cover, and with high visibility into a third quarter, the tests’ excessive pessimism is more obvious than ever. None of the 19 big banks that were tested will come anywhere close to reaching the loss levels foreseen. Regions Financial, for example, predicts its cumulative losses in 2009 and 2010 will come in somewhere between $3.4 billion and $5.9 billion. Regions’ stress test forecast for same period: $9.2 billion. As I say, not even close.
4. Banks are seeing strong deposit inflows across the board. Regarding deposits, virtually every bank that presented said the same thing: deposits are flooding in the door. I didn’t get the sense, though, that many banks realize that a good portion of the strength is the result of a favorable macro environment, not the strength of their brands or their own marketing pizzazz. Of course banks are seeing deposits zoom: capacity is falling as weaker competitors fail. Plus, savers and investors, now aware that even money market funds can blow up, crave safety. This is the high tide for deposit growth; whether bankers know it or not, the tide will eventually go out.
5. Failed-bank acquisitions look promising. A number of presenting banks, notably BB&T, JP Morgan Chase, Wells Fargo, and Zions, have acquired failed institutions in the past year. Each deal is different, of course. But in general, they all will likely end up being meaningfully accretive to earnings, and will provide high returns to the acquirers, even if the acquirer’s assumptions are tempered.
There are obviously more transactions to come. But now that the economy has turned and the credit cycle is more transparent, more bidders will emerge for each deal, which will make for more competitive bidding and, inevitably, lower returns for the eventual buyers.
6. The outlook for net interest margins is extremely encouraging. This is most important for regionals, which derive a very high percentage of revenue and earnings from net interest income. Margins were hit by a triple whammy in 2008: credit costs rose, deposit rates zoomed due to irrational competition and a scramble for liquidity, while short-term index rates tied to bank loans collapsed. Most banks saw their margins bottom back in January; they have been rising ever since.
Margins will likely keep improving for the rest of the year, as deposit costs fall and spreads widen on commercial loan renewals. Then at some point in 2010 (and continuing for thereafter) margins should further benefit as the impact from non-performing assets declines.
A year ago, the Barclays conference was called the Lehman Brothers conference. Since then, Lehman has disappeared and the financial services industry has endured a whirlwind. Now, a year later, the message seems to be that something like normalcy is just over the horizon. That’s very bullish—which is why we remain long several regional bank stocks.
All in all, things sound pretty darn bullish
What do you think? Let me know!