Uncertainty leads to rising risk aversion and fear, but it can also lead to opportunity. Financial markets are focused on the European sovereign debt crisis, growing political and policy risks and a slowdown in global economic momentum. At the same time, a dark cloud of heightened regulation overhangs the global banking industry while the market awaits the release of the European bank stress test results in mid-July. Naturally, investors have lost some confidence in risk assets and in banks due to a lack of clarity surrounding peripheral Europe, global banking regulations and the world economy.
We believe the probability of a near-term default in Greece has increased due to many factors. Greece has high debt levels and lacks sufficient growth, and is also facing bank deposit outflows, credit tightening, deep austerity, rising social unrest and challenging political realities. Greece lacks fiscal union with the EU despite sharing a currency and monetary union with the rest of Europe; this makes policy coordination a challenge and deep austerity measures difficult to enforce. The country’s inability to devalue its currency or set independent monetary policy means Greece can’t regain competitiveness, grow fast enough to service its high debt burden or inflate it away. Fundamentally, Greece has a solvency problem and not a liquidity issue. Although a Greek default and restructuring is likely just a matter of time given these dynamics, the potential spillover into the overall global economy varies dramatically.
The opportunity in today’s market is to distinguish between the strong and the weak in an uncertain world where most investors tend to go from “risk on” to “risk off” with relatively limited differentiation. We prefer to take risk in areas we believe have high expected risk-adjusted returns and avoid risk in areas with low expected risk-adjusted returns. In addition to Greek and sovereign debt concerns, heightened macro and regulatory uncertainty is putting pressure on global banks, creating opportunities for investors willing to do their homework.
Several members of PIMCO’s global credit team specializing in banks and financials recently traveled with me to New York for on-site due diligence meetings with CEOs, CFOs, treasurers and senior executives at several U.S. banks and specialty financial firms. Our meetings reinforced our conviction that today’s dark clouds may give way to clearer skies, particularly if the economy regains momentum and Greek and European sovereign concerns ease during the second half of this year. This could not only improve most risk assets but also shine sunlight on select banks that appear positioned to benefit from a gradually improving outlook. Despite near-term uncertainty, we believe credit investments in many banks, and in particular U.S. banks, should outperform various investment alternatives in fixed income (e.g., mortgages, municipals, non-financial investment grade corporate bonds, high yield corporate bonds and emerging corporate bonds) over a longer-term secular horizon due to deleveraging and stronger global banking regulations.
Banks in the New Normal
Investors in global banks and financials face two simple realities over the next several years. First, economic growth in the developed world will likely be below trend due to continued deleveraging of stressed public and private sector balance sheets. Second, global banking regulators are likely to make banks and financial institutions safer by requiring more capital and liquidity buffers.
The combination of subpar economic growth and heightened regulation suggest most entities (e.g., the government, consumers and banks) in the developed world will continue deleveraging. Given this environment, which PIMCO has referred to as the New Normal, it is not surprising in the U.S. that bank lending (and demand for loans) has been and remains weak (chart 1). Nevertheless, the secular journey of deleveraging banks’ balance sheets in developed economies, while a headwind for economic growth, should lead to improving credit trends and fundamentals for bondholders.
In regard to regulation, global banks over the next several years will be adopting Basel III standards for capital, and a relatively small group of systemically important financial institutions (SIFIs) will face additional buffers on top of the minimum 7% Tier 1 common capital ratio under Basel III. SIFI buffers could be up to 2.5%, which translates into minimum capital requirements approaching 9.5% for the largest and most interconnected U.S. financial companies. Regulators are giving banks several years to implement these new cushions (and the official date for compliance under Basel III isn’t until 2019). Nevertheless, we believe banks will race to reach higher capital levels: Stronger banks will likely gain market confidence much faster than weaker banks as Basel III requirements, SIFI buffers and deadlines become clear over time.
Global banks can meet higher capital requirements through retained earnings, restricting and limiting dividends and stock buybacks, asset divestitures or equity infusions. Higher capital buffers under Basel III will likely be the main driver of lower return on equity (ROE) as banks are required to build more equity cushion:
Return on Equity = Return on Assets * Assets / Equity
(lower) (roughly stable) (lower under Basel III)
Although the outlook for lower return on equity is challenging for bank equity holders, lower leverage and higher capital requirements are supportive for bondholders. PIMCO has long supported this view (see the December 2008 U.S. Credit Perspectives: “Credit Now, Equities Later”), which is why it is not surprising banks’ equities have underperformed relative to banks’ credit spreads over the past several years (chart 2). Simply put, the New Normal and global banking re-regulation have supported bank and financial investments higher in the capital structure at the expense of investments at the bottom of the capital structure.
While higher capital requirements help make banks safer and – all else being equal – are favorable for creditors, we should remain cognizant of potential negative unintended consequences across the capital structure if regulatory regimes prove overly onerous. In turn, we challenge global regulators to strike a thoughtful balance between preserving the safety and soundness of the financial system while also fostering economic growth.
Although re-regulation in the global banking sector will likely continue to favor bondholders at the expense of equity holders in most cases, the factors driving the outlook for global banks – fundamentals, technicals and valuation – will be the main drivers of relative performance going forward. And for most large cap U.S. banks, most of these areas have turned or are set to turn increasingly positive.
Fundamentals Improving for U.S. Banks
Global banks vary dramatically in their asset quality and ability to meet Basel III capital requirements over time. As a result, we believe financial markets will continue to reward the strongest and safest banks and penalize the weakest and riskiest banks. Re-regulation will only act to accelerate this trend through improving transparency and accountability.
Among global banks, U.S. banks have relatively limited exposure to government debt of the weakest peripheral countries (Portugal, Ireland, Greece and Spain) – especially in comparison to European bank counterparts (chart 3). Thus, U.S. banks are in a stronger position to absorb deterioration in the macroeconomic environment in Europe. While some European banks are well capitalized and better able to buffer peripheral weakness, we believe U.S. banks offer investors a more attractive risk/reward profile in the global banking universe, given their relatively low peripheral exposure together with less indirect credit exposures throughout Europe. U.S. banks’ relatively clean balance sheets should help support low funding costs whereas other banks with more direct or indirect European peripheral credit exposure could see pressure on borrowing costs due to concerns over future write-downs on peripheral government debt and loans.
U.S. banks also look relatively attractive in the global banking universe given their profitability. The “big four” large cap banks in the U.S. – J.P. Morgan, Bank of America, Wells Fargo and Citigroup – collectively generated roughly $140 billion of pre-provision earnings annually as of 31 December 2010, according to PIMCO research. The organic capital generation capability of U.S. banks is a strong positive and remains supportive for balance sheets, particularly as asset quality improves. Due to these very high pre-provision earnings levels, U.S. banks can remain profitable in most environments due to a significant funding advantage relative to their global competitors. U.S. banks are largely deposit funded at low costs; for example, checking accounts pay roughly 0.01% returns monthly. U.S. banks’ funding advantage vs. global competitors has increased recently as the Fed has kept rates unchanged while other central banks have increased short-term rates. As a result of more reliance on deposit-based funding, net interest margins (NIMs) range from 3%–4% for the major U.S. banks per SNL Financial, significantly higher than most global banks in developed countries.
Adding to the U.S. banks’ funding advantage are two factors that have gone relatively unnoticed by most investors – improving asset quality and capital position. In asset quality, U.S. banks have turned the corner to see trends improving in early stage delinquencies, delinquencies and nonperforming loans (chart 4). As the U.S. economy has gradually recovered, banks have been able to release reserves as delinquency trends in loans have peaked and charge-offs have come down substantially across almost all asset types (e.g., commercial and industrial loans, credit cards, home equity lines of credit, mortgage loans, commercial real estate, construction loans, etc.). As banks reduce loan provisions and charge-offs decline, they have been able to grow retained earnings as asset quality improves.
In addition to asset quality, U.S. banks’ capital position has significantly improved. Two years ago, U.S. banks were able to raise capital through the government’s Troubled Asset Relief Program (TARP). Today, most major U.S. banks have raised capital from the private sector to repay the government. Strong capital is allowing banks to ease lending standards and make more loans. However, with the U.S. economy deleveraging and companies and individuals facing rising macroeconomic uncertainty, loan demand has been anemic. In addition, regulators initially prevented and are now limiting banks’ ability to pay dividends and repurchase shares. As a result, improving asset quality is allowing for organic earnings generation to flow directly into retained earnings as banks hoard cash and supply less credit into a deleveraging economy. While a headwind for the overall U.S. economy, capital hoarding and gradually improving asset trends have led to significant balance sheet improvement in the U.S. banking industry. As an example, the major U.S. banks have basically doubled their Tier 1 common equity ratio (under Basel I) over the past two years (chart 5).
Housing a Risk for U.S. Banks, Likely Balanced by Upside Factors
A main risk to U.S. bank asset quality is the potential for further deterioration in the U.S. housing market and overall economy, which could slow down the recent positive trend of improving fundamentals. Housing remains fragile due to high inventories and significant negative equity in select regions of the country. Foreclosures could take up to two years to peak and a sudden change in the government’s support for the mortgage market would be negative. Nevertheless, while we remain cautious on U.S. housing and still expect percentage price declines in the mid to high single digits for the overall market, banks appear sufficiently reserved against further housing market weakness and have the resources to manage litigation expenses and fines such as mortgage put-backs and foreclosure settlements.
More importantly, we are seeing some encouraging signs and evidence that housing prices could stabilize over time.
First, U.S. housing prices have fallen roughly one-third from their peak in the second quarter of 2006 per Case-Shiller. As a result of significant price declines, housing has become more affordable. While a lot of homeowners have negative equity and credit availability is restricted, U.S. housing is looking increasingly attractive relative to rental property (chart 6), especially as rental inflation increases due to a lack of apartment development over the past several years.
Second, U.S. real estate is not only attractive to U.S. citizens: Thanks to a weak U.S. dollar, it is now “on sale” and attractive to foreign investors as well. Brazilian, Chinese and other Asian investors are buying up homes and condos in pockets of the country that saw the greatest price declines, such as California and Florida. Because U.S. housing prices look cheap relative to most major housing markets throughout the globe, foreign demand should remain supportive for U.S. housing.
Third, investors are starting to scoop up distressed properties. A report from CoreLogic shows that shadow inventory in the U.S. – composed of seriously delinquent homes, bank real-estate-owned (REO) property and homes in foreclosure – declined from its peak of 1.9 million units in January 2010 to 1.7 million units in April 2011 (chart 7). The decline is likely due partially to fewer new delinquencies as well as rising distressed sales.
Fourth, the U.S. economy is gradually recovering, which is leading to modest improvements in job creation and confidence. Over the past several years, homeownership rates declined due to a weak economy and tight credit, and many unemployed college graduates and laid-off workers moved back in with their parents instead of entering the housing or rental markets. Looking forward, however, given gradual economic recovery and job creation, we should see housing prices eventually stabilize as the demand for housing picks up. Rising rental inflation suggests this is already occurring and that “animal spirits” are gradually improving for U.S. consumers, despite concerns over persistent structural unemployment and heightened global economic uncertainty.
Finally, new housing supply could be constrained by several dynamics. Delinquencies appear to have peaked, so if prices eventually stabilize, the pace of new foreclosures and added future inventory should slow. This will allow the market to clear over time as new households form, the population grows and rising demand absorbs today’s inventories. These diminishing inventories would help ease the current supply/demand imbalance in U.S. housing. Also, home builders are not making the same mistakes they did in 2005 and 2006, when they overcommitted to new homes starts and future land development. Part of this is by choice, and part is due to a lack of credit availability. As a result, outside of trends in the shadow inventory, we should see relatively limited new inventory entering the market.
Over time, the combination of all the above factors should provide support for U.S. housing and thus add momentum to the current trend of gradual improvement in banks’ balance sheets.
Technicals Supportive for U.S. Banks
In addition to gradually improving fundamental trends, we expect positive technicals to support investors in U.S. banks. Despite refinancing needs under the FDIC’s Temporary Liquidity Guarantee Program (TLGP), U.S. banks have relatively limited issuance needs, particularly relative to European banks (chart 8). This is because U.S. banks have less need to grow their balance sheets given the weak economic recovery and uncertainty surrounding regulations under Dodd-Frank legislation. Given this environment, banks are shrinking their balance sheets, deleveraging and maintaining abundant liquidity through large deposit bases and liquid securities portfolios.
The government also appears willing to establish a regulatory framework for a covered bond market in the U.S., which would help to lower U.S. banks’ funding costs. Instead of funding through banks, U.S. covered bonds could be allowed to pool residential and commercial mortgages into debt securities. And unlike in Europe, U.S. covered bonds would include the ability to fund auto loans, credit cards, student loans and government-guaranteed small business loans as well.
The U.S. banking system’s abundant liquidity is shown in recent trends in the differential between three-month U.S. dollar LIBOR overnight index spread over the federal funds rate (chart 9). U.S. banks show few signs of stress as concerns over credit extension and liquidity have abated. Today’s environment of relatively solid confidence in the banking system stands in sharp contrast to the financial crisis in 2008 after the failure of Lehman. During that period, banks hoarded cash and investors were unwilling to lend to banks, pushing liquidity stress indicators to historically wide levels. However, in the years since and with the assistance of quantitative easing, banks have increased their excess (cash) reserves on hand and have increased their utilization of bank deposits as a preferred funding mechanism vs. commercial paper issuance. These improved funding tactics, in addition to enhanced regulations and capital requirements, should continue to improve transparency and confidence within the banking system, and should support U.S. banks going forward.
Valuations Attractive for U.S. Banks and Financials
With gradually improving fundamentals and supportive credit market technicals, U.S. banks and select specialty financials will likely outperform the broad credit market. This is particularly the case today given the attractive valuations in the financial sector. Bank and financial credit spreads remain attractive relative to industrial credit spreads (chart 10). While the U.S. industrial sector could be more vulnerable to a below-trend economic environment and may also entertain more shareholder-friendly activities, U.S. banks remain focused on a longer-term, secular deleveraging trend and are set to continue to strengthen balance sheets due to heightened regulations.
We believe stronger global banking regulations are critical for the safety of banks. The global financial crisis highlighted not only the need for improved regulatory oversight but also the need for strong bank balance sheets given the importance of healthy banks to the global economy. Fortunately, in the U.S., policymakers proactively supported the recapitalization of U.S. banks at a time when they needed it most. As a result, most U.S. banks have turned the corner and over time appear well-positioned to be able to meet the higher capital requirements under Basel III due to healthier balance sheets, solid retained earnings and gradually improving asset quality.
Over the past several years we have seen regulators both punish banks and try to make them safer. My hope is that global banking regulators can begin to transition into a new era of working effectively with governments and banks, particularly with those financial institutions most in need of capital, to help promote equity infusions and assist in providing more stability to both financial markets and the global banking system. Higher capital requirements and re-regulation are expected to be positive for bondholders because they improve transparency and should help make banks safer.
Although the global economy faces uncertain times, U.S. banks and select financials stand out within the global credit markets by offering gradually improving fundamentals, supportive technicals and attractive valuations. Given these positives, we believe select credit investments in U.S. banks and financials offer the opportunity for attractive risk-adjusted returns as today’s economic dark clouds gradually give way to more sunlight.