What I Learned from Reading Bank Reports

Every quarter I read through a bunch of bank reports and earning calls.

Honestly, it’s a little dry.

I already wrote about what happened last fall when I went through the Q2 2022 reports.  In September I had a bit of a WTF moment as I saw:

1. The tangible book value of almost every bank collapse – some by 30-40%
2. No one seeming to care that this had just happened

I wrote at the time:

Again, I don’t know what to make of these OCI hits. Do they matter? I’m not sure. They certainly make the bank look more expensive on a book value basis. Post the OCI hit, the bank is closer to running into regulatory trouble if something goes wrong with its loan book. OCI hits don’t impact earnings, though as I said they might impact the ability to grow earnings in the future.

Just to be safe, I’ve stayed away from banks with big securities portfolios that are taking big OCI hits. Funnily, its either the very small banks or very large banks that aren’t having to do that. The small banks don’t own a lot of securities. the largest one’s (like C, BAC or JPM) seem to be better at hedging their exposure.

I was just kind of like – does this matter?  And I concluded that it probably didn’t matter.  Unless someone decided it mattered.  And then it might matter a lot.  So it was best to just stay away, just in case.

This quarter (q1 2023) I did the same thing I always do except even moreso.  I’ve read through a lot of reports and calls.

I went into this quarter thinking there might be another big “Holy Cow” moment from hearing what the bankers had to say.   But you know, there wasn’t.

Instead, the problem I think is more insidious.  Insidious – harmful but in a gradual, subtle way that takes time to show what is really going on.  It is the frog slowing boiling and not knowing it analogy.

The problem, which we all know, is that short term rates went from 1% to 5% in a year and banks can’t adjust to that fast enough.  I mean that’s really it.  Everything else is a consequence of that.

Consequence #1 is that deposit costs are just dripping upwards every day.  I pointed this out in my post on PNC.  Some banks saw 50 bps increases to their deposits in Q1.  Some saw as much as 100 bps increases.  But it’s going up for all of them.

The loan books can’t go up as quickly.  In part that is because they already have moved up, which pushed this problem from last year to this year.  In part it is because a bank can only roll over at most 20% of their loan book in a year.  And also only in part because some of the loans are variable rate which do go up and down with short term rates.

There are lots of factors.  Things can be very different depending on the bank.  What really matters is the net interest margin (NIM) – the spread between what the bank lends at and what they pay for deposits.  In Q1 some banks saw their NIM fall quite a bit as deposits rose and their loan and security book didn’t rise with it.  That isn’t a good thing.

But not all banks saw this.  For some NIM just moved down a little.  And some banks that had very “sticky” deposits or a lot of variable loans actually saw their NIM rise.

But most saw it fall at least a bit.  And it will fall again in Q2.   Now again, another nuance: some banks will try to offset this falling NIM with new loans.  And you heard that on various calls.  We’ll grow our way out of it.

But other banks can’t do this so they didn’t really talk about it.  These banks have a lot of loans on their balance sheet already (loan to deposit ratios of >100 while FRC, that bank that just failed, was actually only 95 in comparison) and so they can’t make a lot of new loans.  They are kind of stuck.

If you see a bank with a smallish NIM to begin with (<3% or yikes, <2.5%) and high loan/deposit ratio, that’s not a good thing.

Another thing I noticed is that most of these smaller banks own a lot of commercial real estate loans.  Bank after bank has 30% or 40% CRE.  The outliers have 90%+.  Very few banks don’t have significant exposure to CRE of one type or another.

Now not all of that is office.  There is industrial, retail, multifamily.  The one’s that have office are in probably the most hot water, and you can see that because every bank that didn’t have big office exposure told us they didn’t have big office exposure.

You get a hint of the problems with office exposure every once in a while.  For example, consider the following exchanges from one bank call:

And then later in the call:

As Seinfeld said, that’s a big matzah ball! 

So there’s office.  Its not great.  There are pockets of multifamily that aren’t great if you can’t raise rents (like in NYC or hmm, there was some city in Canada that did something like this, it will come to me…).  There are malls.  Lots of stuff that is a bit wobbly.

But I don’t think in and of itself these CRE loans would be a problem.   The banks would manage out of it.  It is like I said, every bank is different.  Some are more exposed, some less, a few will stumble, most won’t.

The bigger issue is Consequence #2 of the rise in rates.   And that is that the loan books of all the banks, every one of them, is underwater.

Any bank that wrote a fixed rate loan between 2020 and 2022 is underwater now.  Its not really their fault, its just the way it is.  They made the loan when fed funds were 0% and treasury rates were 1% and now rates are higher and so the loan is worth less.

Now NO BANKS talk about this on their conference calls.  There wasn’t one bank that talked about the mark to market of their loan book.  Because its not a good thing.  It’s a lot like OCI was last fall – better left unsaid and it isn’t a problem unless someone decides it is a problem.

Which brings up one interesting thing I did a couple weeks ago.  I went way all the way back to the summer of 2008 and read what a bunch of banks said on their Q2 2008 conference calls.

This was like 3 months before all hell broke loose.   And you know what?  They didn’t have a clue.  Or at least, they weren’t going to say it.

The best you got out of bank comments was a bit about tightening conditions at the edges, a little weakness here or there.  Seems like housing is a little weak.  Absolutely no blazing red flags.

So you can’t just listen to what they say.

I suspect that one of the reasons the banks have fallen out of bed this week is because when FRC went belly up over the weekend and was bought by JP Morgan, the loan book was bought for about a 13% discount and that is with a loss sharing agreement.

Think about that for a second.  The entire loan book of FRC is worth 13% less than the number on the balance sheet.

What would that mean if you had to sell the loans at fair value for every other bank tomorrow?

Again, its nuanced – some banks would be fine, others would be not so much.  But I’ll tell you, when this whole thing started back in March I went through the 10-Ks of about 30 banks and what I saw, where it was reported, was an average loan book down ~10% when it was marked to market (this wasn’t quite hidden at the end of the 10-K so you really had to hunt for it, but it was often disclosed).

It was pointed out somewhere that there were about $25-$30 trillion of loans made in 2020 and 2021 (I’m not sure if that is just banks or all financial entities, I’m getting this second hand but I think that number is ballpark right), when rates were super-duper low.  If you do the mark to market loss on that at a 15% haircut, that is in the range of $4 trillion of mark-to-market losses, just sitting there.

Now does that matter?  It doesn’t really matter if no one cares.  Its all held on the balance sheet of banks who don’t really want to sell it so if they don’t have to sell it then who cares.  But if it starts to matter, it would REALLY matter.

Which is why I just need to be a little bit careful here.