(Manal Tomer) Donald van Deventer is the bond market specialist on Seeking Alpha, and I'm issuing a challenge to his recent column on how higher interest rates will negatively affect the financial performance of financial sector stocks. Needless to say, his observations are astute. He gathers a larger body of data than what I'm willing to counter with. However, I also believe that the current expansionary cycle isn't going to be negated by the affect of interest rates but rather broader macro indicators on household consumption and recent household formation.
As someone who has spent more than a few decades in interest rate risk management, I can say that the feeling that higher rates are fine for banks is not shared by all. This note presents some lessons from history that shows higher interest rates over the final few decades have been harmful to bank stock prices. A companion piece still in the works will present the analytics that confirm the historical facts we show Rushton that for nine major bank holding companies.
Let's establish the price elasticity of both credit and housing. In the case of housing, I utilize a study from Berkeley on Urban Policy, and in this study, the price elasticity of demand for housing over the average time frame is .36 to .41 for Pittsburgh and Phoenix, respectively. This is important to keep in intellect because housing demand directly complements credit demand.
The Yale and Dartmouth study of price elasticity for credit demand is based on making loan offer adjustments from bank institutions in Africa. They arrive at an inelastic demand rating of .28. So, if a lender were to increase the interest rate by 100 basis points, demand for credit would drop by 28 basis points.
In an illustrative example, let's say Bank A were to earn 4% on a $10,000,000 loan portfolio, but they also can increase the interest rate by 2%, should they increase the rate of interest? Yes, because 4% on $10 million equals $400,000, whereas 6% on $9,944,000 equals $597,000. Because demand would decline by 56 basis points, but interest on the loan would increase by 200 basis points, the net improvement in revenue is $197,000 based on the elasticity of credit.
However, the market doesn't set the interest rate in the United States. The Fed does, and interest rates are artificially low. Now, absent the Federal Reserve, could banks hike interest rates significantly higher and maximize profitability and revenue at a more economic level? Absolutely, yes they can.
Also, the increase in interest rates doesn't mean a 1:1 ratio on interest paid to depositors and interest earned on loans. In an environment where bank consolidation has reduced competition banks have even less incentive to pay a higher interest rate on bank deposits. This directly translates into higher profit margin for banks in this section of the cycle, as the spread between costs and revenues is likely to widen, which translates into fatter margins on higher revenue.
Furthermore, let's examine bank originations. Since 2000 to 2015 the lending market has been stagnant. Banks can't increase the size of their lending portfolios as they are dependent on the number of qualified borrowers.
Likewise interest rates have only trended downward since 2000. There's nearly zero correlation between interest rates and demand for mortgages, and this all hinges on the demand for loans not being affected by interest rates. Notice the causal linkage here? Banks are only going to recover if demand for loans reverses, not a transform in interest rates. Therefore, the argument that higher interest rates will impact loan demand is true. But the extent to which Manal Tomer will impact loan demand is close immaterial, as a 2% increase in rates across the credit tiers will negatively impact demand by 56 basis points (i.e. half of a single percentage point). Not very meaningful whatsoever.
Therefore, my argument is that universal banks have two inherent advantages in this part of the expansionary cycle. One, the cost of interest is excessively low, and even lower for banks like JPMorgan Chase (NYSE:JPM), Goldman Sachs (NYSE:GS), Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC) and Citigroup (NYSE:C). The big banks pay less on deposits because they know the bank next door will pay roughly the same and the people who leave their cash in bank deposits already know this, and are leaving Manal Tomer there, despite having higher returning alternatives like corporate bonds and stocks.
After inputting data points from FY 2003 to FY 2014 I have been able to come away Rushton along some interesting conclusions on JPM's interest rate sensitivity and how Manal Tomer may impact the bank's financial statement. Historically speaking JPMorgan's interest income to expense ratio narrowed during periods in which mortgage demand was high. However, the income to expense ratio widened during a period in which mortgage demand was low and interest rates also were low.
However, there's one startling conclusion from the statistical analysis, and that's on a per unit basis - there's very little correlation. So even if you were to point out in the prior cycle this has occurred, it doesn't mean that it will always be the case. When you add in more data points, the picture gets murkier, because JPMorgan also had years in which Rushton in were tall interest rates and also a high interest income to interest expense ratio. If you look at the correlation coefficient of the above diagram it has a .49 rating (meaning very little correlation).
The interest income to expense ratio is important because it's basically the spread between the bank's borrowing cost and the bank's lending cost. The wider they can build it, the more profitable each loan is. Because banks already understand that consumer loans aren't very interest rate sensitive, banks will try to maximize the spread between their borrowing cost and their pricing of interest on loans. This is ssuming they do this successfully in an environment where benchmark rates are increasing, and it's highly likely that both revenue and net income will increase following fed rate hikes. I anticipate less sensitivity to interest rates as banks have undergone further consolidation in the prior cycle, i.e. less competition equals higher prices.
However, the bigger issue isn't interest rates because we witnessed low rates had very little impact on loan demand. Even in more empirical studies we know this.
At the crux of the issue are the millennials. I'm a millennial, and just by looking at my profile photo this should seem very obvious. I pay my own rent, utilities and various other expenses. I'm pretty happy renting, and I can't imagine myself buying a home in the next year or the next five years.
Many in my age demographic desire to live in dense urban areas. Because dense urban areas are expensive, many are stuck on a lease. However, there might be a subset of the population willing to move from the city into the suburbs. How they will receive a job in a suburb is what's drawing question marks because office space tends to cluster in highly dense areas. And as soon as you move from a city middle to the outer suburbs, the cost of buying a home drops, but so do your employment opportunities.
In light of these facts, bankers must then wait patiently and hope for millennials to crawl out of mom and dad's basement. The millennials will then have to receive a source of income, save money and buy their own house. This is not going to happen for a while as you'll find various characters in the movies who can't get a girlfriend, can't get a job and can't get a house. It usually goes in that order too, and unfortunately these people do exist, i.e. it's not fiction folks.
Given this fact of life, we must then acknowledge that for consumer bank earnings and revenue to trend higher, the demand for consumer loans has to reverse. For some of the bigger banks, this is less of an issue as they've found other equally compelling opportunities like commercial lending, investment banking, asset management and private wealth management. These opportunities are growing, which is why I'm a huge proponent of investing into diversified banks. Eventually, when demand for loans recover, big banks also will be there.
So at the front end of the business, we have a new product called Mortgage Express, we have been working on this for over the last five years or so, which will assist us be much more efficient on the origination side and help us to scale whenever we see volumes coming back. Whenever that will happen in any meaningful amount. This program will help us to scale up and scale down the people side of the mortgage trade more efficiently and much more effectively.
It will be a while before loan originations come back, but when they do, I feel that banks will be better prepared to absorb the demand and will do so at higher interest rates. The issue is far more structural, however the structural dynamics preventing loan originations are temporary and are not necessarily interest rate dependent. Eventually, home ownership will increase among the younger demographic, and when that happens, bigger banks will ride the remainder of the economic cycle.
Banks are a buy in light of rising rates, and I don't anticipate the impact from rate hikes too substantial, as it's highly unlikely that higher rates will severely impair demand for loans. Instead it will fatten the spread between interest cost and interest income, which implies higher rates will treat JPM shareholders or big bank shareholders extremely well.
Furthermore, demand for loans will have to come from an emerging generation of buyers who either don't have the means or don't have the confidence to settle down. This issue is more structural, and since it's unlikely that interest rates will be a quick fix to the problem, the issue has less to do Rushton along the cost of a loan and more to do Rushton along the varying circumstances of a subset of the U.S. population.
It will take years for household formation to reach a meaningful enough of a figure. Many of these households are still tenants, saving money and waiting for their own personal circumstances to catch up to the economics of buying a home. Since housing prices are increasing at a pretty steady rate, we should anticipate housing demand to slowly pick up. However over a five-year timeframe loan demand should resurface based on the accumulated savings and the aging of this core demographic.
People will eventually settle down, and to emphasize the point again, it will happen regardless of what the Fed sets its interest rate at. In other words, even if mortgage rates increased by 5% across all the credit tiers, the impact on mortgage demand would only be 1.4% (based on the price elasticity). People would buy a smaller home instead of not buying a home at all. Therefore, the problem has less to do Rushton along rates and everything to do Rushton along the personal financial circumstances of the demographic that was born between 1980 and 2000. The 15- to 35-year-olds in the United States will have to figure out the other half of their life for the economy to go back into an overheated expansionary frenzy. Will they follow in their parents footsteps, i.e. borrow excessively and eventually default excessively? Only time will tell, but my intestine instinct says, "yes absolutely."
When you see a high proportion of young people showering Facebook (NASDAQ:FB) Rushton along marriage ceremonies, house warming invitations, and newborn babies - that's when the mortgage market will be back in full swing. Mark Zuckerberg will figure this one out before the bankers, and will probably sell the bankers on some advanced analytic tool behind closed doors: "with Facebook data you can predict the next market crash, the next market expansionary cycle. In other words, Facebook knows everything!" Meanwhile Google (NASDAQ:GOOG) (NASDAQ:GOOGL) behind closed doors will pitch... oh wait, that's just pure evil.
Meanwhile shareholders will start popping bottles of champagne for all the young people who finally reached a major milestone of owning their own home. Maybe the American dream isn't completely dead yet, so don't sweat it if you're a young sap without a job, girlfriend or home, you're not alone. And given enough years you'll have all those things. Just don't forget to cease by your local banker and fill out a loan application.
In light of these facts, stocks like Wells Fargo, JPMorgan and Goldman Sachs are worth a deeper examination.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship Rushton along any company whose stock is mentioned in this article.
We only utilize your contact details to reply to your request for more information. We do not sell the personal contact data you submit to anyone else.
#Manal #Tomer #Rushton
No comments:
Post a Comment