Flat Out: How the Economy is Impacting Regional Banks
Today, March 22, 2019, the yield on the 3-month T-Bill traded higher than the interest rate on the 10-YR Treasury note meaning short term debt was yielding higher than long term debt which is referred to as an inverted yield curve. This spread had not been negative since 2007 and is generally perceived as a recession indicator when looking ahead 12-18 months. This comes after the Fed on Wednesday expressed intentions to discontinue quantitative easing (e.g. the process of selling its stockpile of bonds and MBS from its balance sheet) while also announcing expectations of steady rates in 2019. This means the Fed has essentially removed itself from growth tempering which began to accelerate through 2018 and is now on the sidelines anticipating weakness ahead.
All of this is great if you’re a bank simply looking for pure purchase and refinance mortgage volume. It’s even better if you’re a bank in low tax regions experiencing growth from population migration, like the Southeast US, or where affordable housing can be found. Though, by and large, it’s bad if you’re a bank relying on profitability from the wider interest spread between your variable rate loan products for which you’re utilizing a T-Bill rate; one in highly competitive regions with low inventory and less incentive to purchase with lower SALT deductions; one with a poor user interface trying to compete with non-bank lenders like Quicken; one with a high cost to originate; or generally one who plays conservatively with rates and policy. It’s even worse if you’re a bank with an upside-down liquidity ratio, weak core funding or borrowing short term debt to make long term loans. Big banks often have the capital and risk appetite to hold higher risk / higher yielding portfolios like credit cards, which generally utilize the prime and LIBOR rates. These indices float independent of Fed rate decisions.
The cost of funds moving opposite the direction of loan rates significantly compresses the earning power of banks, especially those with a heavy cost structure, e.g. those with many branches, overweight staff, sunk technology costs, etc., and/or those without strong complementary lines of business with strong fee income potential. One way of reducing those costs is through merger, which is why there’s been so much activity in the M&A arena including the recent merger of equals between BB&T and SunTrust.
A look at mid-size and regional bank stocks today shows this anticipated weakening in earnings. Looking broadly at the ETFs which track the entire sector, XLF is tracking down >2.50%, and KRE which tracks regional banks specifically, is down >4.00%. Overall, these numbers and indictors suggest lower expectations for growth and profitability in the banking sector in the near term.