Let's Talk Loans - Vol. 85

Welcome back to another discussion about banking and lending. Each week we tune in to chat about what's trading and trending in the whole loan market. If you're interested in shop talk from the Raymond James whole loan desk, you've come to the right spot. Please subscribe, like or share this newsletter if you enjoy the discussion!

Let's dive into the credit union universe for a moment. They are in a somewhat unique "banking" pickle. For those unfamiliar with this corner of banking, the only way credit unions "raise capital" is through earnings. I'm ignoring subordinated debt for simplicity's sake. This makes growth a challenge in a market where rates are relentlessly going up. It's hard to find assets that are in-the-money due to the Fed's recent onslaught on inflation. The CU Times article below articulates this showing the recent impact to ROA. Earnings have absolutely tanked.

"That was the lowest full-year ROA since it was 0.67% in 2011, two years after the end of the Great Recession. ROAs during the Great Recession were 0.63% in 2007 (the recession began late that year), -0.04% in 2008 (its worst year), 0.20% in 2009, when it officially ended, and 0.50% in 2010."

But why have originations fallen? Let's look specifically at the NCUA data (as of Sept '23) to tell the story. It starts with the pandemic. Below is the graph of deposit growth and tied to loan growth. We all remember that cash flooded in, deposits (shares for CUs) skyrocketed, but we were in lockdown and making loans in a branch-based network was near impossible. As the world re-opened, credit unions (and banks for that matter) raced to put all this excess cash to work. You can see how share growth started to plummet just as loan growth took off. That loan growth was perfectly at the wrong time. Rates started to rise just AFTER credit unions put the lending peddle to the metal. Credit unions (and banks) made a bunch of underwater loans just as the Fed started to hike. Those loans (particularly resi mortgage) have now extended, prepayments have cratered, the cost of new deposits has spiked, and provisions are on the rise.

As you look at shares (deposits) for credit unions you can see the trend. Similar to banks, it's not to say they are "losing" deposits as much as they are moving into different buckets. "Certificates" are what banks would call CD's. This is what is happening with banks when the consumer (or member) wakes up, takes money out of no cost checking account and pushes it into more expensive instruments. However, you can see the non member grouping starting to grow. That's what you and I would call wholesale borrowings. Brokered CDs, FHLB, etc. The cost of deposits remain an issue, loan to share ratios are at decade highs and now credit unions are starting to look to borrowings to fund future loan growth.

So now that deposits are under pressure, borrowings are rising and credit unions are having to slow down lending. Or at worst, raise rates so that loans originated are profitable. Across nearly every lending category, YoY product volumes are down. The Q4 data hasn't been released yet but I expect these numbers look worse during the next release. Making fewer loans at current market rates negatively impacts earnings as fewer higher coupon loans help overcome the rise in provisions and deposit costs. In addition, credit unions have fewer higher coupon loans that they can sell at premiums which would immediately help the problem. From a trading standpoint, we are seeing fewer and fewer loans available for sale that are "in-the-money" due to falling originations. Now is the time to make loans at higher rates but credit unions are out of cash. We encourage those credit union clients who have strong auto and HELOC engines to call us as the demand for those assets are driving very attractive premiums right now that can be sold almost immediately giving earnings a shot in the arm.

The next shoe to drop are provisions. Charge offs have started to climb, and provisions have grown with them. Put it all together. Higher cost of funds. Higher provisions. Lower loan growth. Results in a deep drop in earnings. Which leaves credit unions with an interesting challenge - how do you grow in this environment? They have really two choices.

1. Merge. Smaller credit unions (or banks) that still have a cheaper source of deposits will be gobbled up by larger, more efficient engines of loan growth. The challenge there being that the assets today are deeply underwater making the math difficult. However, should we get a bit of a relief in rates later in the year I would expect to see an explosion of M&A.
2. Survive. You'll have to slow down loan growth in the short term. As you receive new cash flow from existing loans or bonds, redeploy those dollars into higher earning assets to improve earnings. The focus today has been to preserve capital, doing little to impact future positive earnings and slowly dig out of this hole through retained earnings.
3. Historically you might argue there is a third category - shrink. The challenge being that both loans and bonds are so deeply underwater any attempt to sell meaningful volume from the existing balance sheet would just butcher capital. Further, it wouldn't give you enough benefit for the pain inflicted. Instead, you're forced to limp through current conditions and survive to fight another day.

For those doomsayers on CRE, the below post is for you! Fortress joins 彭博资讯 's "Credit Edge" podcast to talk about the potential pain coming to the CRE market. Regular readers of LTL will know that I struggle seeing the underlying loan portfolios out there coupled with the narrative that a soft landing will allow depositories to extend and pretend their way out of this.

"More US banks will fail as the commercial real estate crash begins to work its way through to lenders' balance sheets, according to Joshua Pack, co-chief executive officer at Fortress."

As I wrote last week in LTL, CRE lenders have two challenges. Underwater rates AND credit problems. When or if ever a shock does come to the CRE sector, I would side with Joshua Pack . Presently, extend and pretend is the word of the day and its working with a strong economy.

Another disappointing week for rates. The below article from Bloomberg highlights many of the Fed votes and their tone for when that first rate cut might come. The market now has factored in only 3 hikes for 2024 with that first full cut in July. It feels as if the market has taken its medicine and that the unrealistic expectations set back in November have reversed. We started on Feb 1 with a 3.88% 10 year and it sits at 4.32% as of this morning. The 2 year was 4.20% and now is a whopping 4.71%.

This recent back up in rates has impacted the mortgage market as well. The sub 7% and even sub 6.5% mortgage market was fun while it lasted but we've trickled our way back up above 7% as of this week. I suspect we find ourselves in a bit of a trading pattern here until we get more clarity into that first cut. The good news being I don't think we have too much more to go as the treasury market has reset their expectations based on recent Fed speak.

Lastly - we're at the onset of spring conference season. Saturday afternoon I board the long flight from Memphis to Vegas. Sunday afternoon I'll be presenting with my peers at 1pm in Pinyon Ballroom 8. Monday will be a day of speed dating as we meet with over 20+ clients. If you're in Vegas for the Structured Finance Association 's SFVegas 2024 conference at the ARIA Resort & Casino I hope we can catch a drink together!

#SFVegas #EngageLearnConnect

Have a great weekend! M24-425234