Unprecedented turmoil caused by COVID-19 and the ensuing widespread shelter-in-place orders have cast a thick fog over economic forecasts and the outlook for the banking industry. From the beginning of the year to the low points in March, we witnessed the 10-year treasury yield collapse 75% to 0.50% on March 9, oil prices fall more than 80% to $12/bbl on April 21 and the KBW Regional Bank Index (KRX) fall 49% by March 23, all while the government pumped trillions of dollars into the financial system, individual bank accounts and main street businesses.
More than 40 million workers have sought unemployment assistance in the previous 10 weeks and second quarter U.S. GDP is expected to contract by -34%; including unemployment insurance and CARES Act payments, the pro forma estimate would be for +3.4% growth in GDP.
While many states have started to loosen restrictions on activities, most market observers have abandoned early hope for a V-shaped recovery. It is nearly impossible to summarize the historic nature of the turmoil caused by COVID-19, but for the community and regional banks there are reasons to remain optimistic.
Fortress balance sheets will carry banks through the crisis
Figure 1.
In the midst of heightened uncertainty, and expectations of a prolonged economic recovery, investors have looked to prior financial crises as a guide for what to expect in today’s environment, most notably of course the Great Recession of 2008-2011. However, compared to bank balance sheets at the end of 2007, nearly every metric of bank balance sheet strength was materially more resilient at the end of 2019. Notably, the tangible common equity ratio for the banking system was the highest in 70 years at 9.3% versus 6.6% in 2007, as shown in figure 1.
Equity valuations for banks remain historically low, with the KRX trading at a median of 1.25x tangible book value as of June 5, compared to 1.73x at the beginning of the year. The equity market is reflecting the expectations that bank earnings will continue to feel pressure, primarily from higher provision expenses and lower net interest margins.
As a result, the KRX has underperformed the S&P 500 by 22% year-to-date through June 5, with the KRX down 23% and the S&P 500 down 1%. Contributing to the underperformance is that the vast majority of public banks suspended their share buybacks, which removes an incremental buyer of bank stocks from the market and adds to downward pressure overall.
Figure 2.
Additionally, with no share buybacks, there is further pressure on future earnings per share. It is not likely that share buybacks for banks will return broadly until there is materially more clarity as to the credit quality and earnings strength through the end of the year and into 2021. See figure 2.
Banks are raising capital at unprecedented levels
In an abundance of caution, banks have been issuing subordinated debt and preferred stock at a record pace. There are three primary reasons cited by management teams:
- to support cash needs for dividends and other expenses at the holding company;
- downstream as common equity to the bank if the credit environment proves to be difficult in the coming quarters; or
- to buy back stock if capital is ultimately not needed.
Figure 3.
Year-to-date through June 5, $3.1 billion of subordinated debt has been issued by community and regional banks, already more than all of 2019. Additionally, there have been just under $1.0 billion of preferred issuance for banks with less than $50 billion in assets. See figure 3.
CECL came at a very challenging time
CECL, the newest four-letter word in banking, came at a very challenging time for the industry. The CECL credit loss standard relies heavily on economic forecasts, which are inherently uncertain in normal times and exponentially more so in the current environment.
The result of CECL adoption in the first quarter of 2020 was a provision to loan ratio of 9x fourth quarter 2019 levels, despite roughly equal amounts of net charge offs for CECL adopters. The reserve to loan ratio increased 62% for CECL adopters.
Figure 4.
Additionally, because economic forecasts have weakened since March 31, the market expects higher provision expense in the second quarter. Figure 4 shows the magnitude of additional reserves required by adopters of CECL versus those that deferred adoption.
Texas bank valuations follow oil price volatility
In 2016, oil prices dipped from over $100 per barrel to $26 in a short period. Investors called doomsday and sold Texas bank stocks indiscriminately. Over the ensuing years, some banks took losses in the energy portfolio, but overall the Texas banks proved their underwriting was sound, the Texas economy is diverse and exposure to riskier areas of energy lending was quite low.
Figure 5.
Fast forward to 2020 and the demand shock from stay-at-home orders, in conjunction with a global supply glut, caused oil prices to collapse to historically low levels in mid-April. This once again sent reverberations through the market and Texas banks were painted with a broad brush by investors, which sold off heavily. Already, with WTI oil rallying to the approximately $40 per barrel at June 5, Texas banks have recovered to prices well off their recent lows. See figures 5 and 6.
Bank M&A screeched to a halt
Figure 6.
Another casualty of the overwhelming uncertainty has been bank M&A. From the time that the Paycheck Protection Program (PPP) was announced to first quarter earnings releases, there were virtually no M&A conversations happening. During the months of April, May and June, only five M&A transactions were announced, with no disclosed deal values, compared with 71 M&A transactions totaling $5.9 billion of deal value during the same period of 2019.
Additionally, several deals that were pending going into the crisis were either restructured or terminated. Most notably, Independent Bank Group Inc. and Texas Capital Bancshares Inc. mutually agreed to part ways, citing “the extreme and unpredictable economic conditions … caused by the COVID-19 pandemic.” Today, we are seeing M&A conversations pick up, particularly among parties that were interested in merging before the crisis.
Banks are the good guys this time
Compared to the Great Recession where banks were broadly vilified as contributing to the financial and housing crises, banks today are recognized as part of the solution. Community and regional banks benefited greatly from the PPP program, and regulators have implemented guidance intended to make it easier for banks to work with their customers to bridge the economic gap to the end of COVID-19 lockdowns.
While it can be easy to focus on the risk and uncertainties out there, community banks have largely shined so far in the way they have handled the ongoing public health and economic crisis. The value of a business’s banking relationship has never been greater. Balance sheets are strong and broadly speaking the industry should be able to weather the storm.
Craig R. McMahen and Joe Gulash are managing directors and Stephen Gunlock is a vice president in the investment banking department of Keefe, Bruyette & Woods Inc.