“…next time, let’s just give them the damn number” – probably the most memorable quote from third quarter 2024 earnings season from none other than J.P Morgan CEO Jamie Dimon, which was in response to a question from an analyst about JPM’s net interest income outlook.
I believe the root of Jamie Dimon’s frustration can partly be traced to the increasingly short attention span of investors. So, with that in mind, as third quarter earnings season for banks winds down, let’s not miss the forest for the trees; what are the 3 most critical things we learned?
1. The industry still feels positive about margin expansion, although time will tell.
If you take a general canvass of earnings calls during third quarter, the consensus is margin expansion is coming. There are certainly near-term tailwinds to margin, namely the flurry of 6-12 month retail CDs and brokered deposits that the industry has taken on over the past two years which should easily re-price 20-30 bps lower after the initial 50 bps cut in Fed Funds.
However, I think a degree of caution around margin expansion is still appropriate. Two big uncertainties still loom, competitive dynamics and macro-conditions. We vastly underestimated margin pressure as rates rose, and I think it is possible that margin tailwinds take longer to play-out, particularly if the curve doesn’t steepen and the Fed stalls.
Another consideration is loan growth, which on a net-basis, has really been nonexistent for the industry in 2023 and 2024 year-to-date. It is much easier to reduce deposit costs as short-term rates lower without growing the balance sheet, but if banks start to see net-loan growth re-engage in 2025, the pressure from bringing on incremental deposits could be more noticeable.
The banks that can efficiently fund net loan growth in future periods will be able to sustain the highest valuations, in our view.
2. No broader credit deterioration; but still cracks.
By and large, the industry’s credit performance remains pretty good with no signs of structural credit issues. The U.S. banking sector on average still has quarterly net charge-offs sub 30 bps, and non-performing loans below 100 bps of total loans – both of which still compare very favorably to historical averages.
The most notable exception would still be commercial real estate office loans, particularly in coastal metropolitan areas. Appraisal trends in these areas remain challenging, with one example being a NJ office loan originated by Webster Bank (WBS) which was downgraded in third quarter (with other local banks participating). This loan had received an appraised valuation of $105.1mm in April 2024, but with the borrower now in payment default and foreclosure initiated, the updated appraisal valuation of $36.2mm represented a -65% reduction!
Investors are undoubtedly sensitive to credit risk, resulting in still a lot of bifurcation in the market. Said differently, most banks with exposure to coastal commercial real estate, big office portfolios, or higher non-performing loans, already trade at or below tangible book value. For comparison purposes, the KBW Regional Banking Index (KRX) trades between 1.6-1.7x tangible book value, and publicly traded U.S. banks <$10 billion-in-assets trade at approximately 1.2x.
Looking at third quarter stock performance, there were several tech-forward bank stocks who saw outsized negative movement because of elevated credit migration in their lending portfolios, namely Live Oak Bank (LOB) and The Bancorp, Inc. (TBBK) – even though neither saw material net charge-offs.
To circle back to a prior point, it will be interesting to see how go-forward credit performance impact’s bank’s appetite to accelerate loan growth, although at this point we don’t think it should be too significant a detriment outside of some specific areas.
- Sidebar: Are banks heading back to risk-on mode? A quote from LendingClub’s (LC) CEO Scott Sanborn on their 3Q24 earnings call stood out to us – pertaining to bank engagement in their marketplace for unsecured personal loans.
“We’ve been focused on reengaging banks, which have historically supported higher loan sales pricing. This quarter, we sold a $75 million pool of loans to a previous bank buyer that returned to the platform, and just last week we completed a $400 million sale to a new bank partner. Importantly, we anticipate that these banks will together purchase more than $1 billion worth of additional loans over the next 12 months.”
Small sample size, but keep in mind banks have basically bought near-zero consumer loans from Lending Club’s marketplace (and others, such as SOFI) for the past year and half. So to see multiple banks re-engage and the company generally be optimistic about the outlook for more, definitely could be an early indicator that bank’s appetite for risk is expanding as rates / deposit costs have stabilized. Furthermore, our conversations during the quarter with other banks have supported this view, and I think this could be a critical theme to watch in 2025.
3. The industry still feels positive about margin expansion, although time will tell. Despite prevailing sentiment, I’m confident bank M&A and capital raising will be on the rise regardless of who wins the Whitehouse in early November.
I don’t believe this is a very political statement, but rather one based on historic analysis. To make an obvious point, banks are financial institutions heavily reliant on their balance sheet to turn a profit. There are generally two easy ways to improve profitability, increase your margin or scale on your expense base. The result of these truth’s is bank M&A and capital raising – and the industry should see increased actively regardless of who is in the next President, in our view.
Earnings power just isn’t good enough for the industry today, with a return on assets struggling to stay north of 1.00%.
There were over 200 bank M&A transactions in each of 2015, 2016, 2017, 2018 and 2019, before dropping significantly to 150-200 in 2021 and 2022. More recently though, things have been even slower with 2023 and 2024 seeing less than 100 bank M&A transactions.
There really hasn’t been many periods in time such as this regarding lulls in M&A and capital raising for the banking industry; and given where earnings projections are today and technology threats to the industry, we think the election outcome will be less meaningful to increased activity that sentiment would indicate. Eventually, you have to push ahead with the cards that are dealt to you.
What could be VERY different, however, is pricing – although with the election right around the corner; lets save that conversation for a future piece on Travillian Next!
