Here Comes the Next Big Bank Lending Boom

Includes: IYF, VFH, XLF
by: Todd Campbell
There are always booms and busts in every economic cycle. Those who view the world through rose-colored lenses at the peak in either direction lose heartily, not only in diminished account value but also in opportunity cost. While many continue to bet against banks, the evidence suggests we’re at a launching point for big bank profits. In short, we’re at the starting line for a multi-year lending boom.
I remain convinced we are in the early innings of the boom stage of the economic cycle. Since 2009, we’ve watched railroad carload activity grow week after week, industrial production move higher and noted ongoing expansion in temporary staffing trends, a precursor to broader job growth.
What we witnessed in 2010, whether in the form of more freight being shipped, more job postings online, more temporary positions created, improving retail sales or increasing capacity utilization, is very similar to what we saw in 2004, the first year following the 2003 bear market low, and in the periods exiting prior recessions in the 70’s, 80’s and early 90’s.
In fact, the 2010 sector leaders were eerily similar to 2004, with industrials, consumer discretionary, energy and basic materials all outperforming the S&P 500.
In 2011, we expect the economic recovery will continue to pick up steam, suggesting that in 2012 we’ll refer to 2011 as the beginning of the next big bank profit boom.
We’re already seeing the signs of a strong foundation having been poured. The Fed’s cheap money policy, mixed with improving default rates, is allowing banks to recapture “deferred” earnings through reserve releases – an early sign of overall industry improvement. Meanwhile, net interest margins, the lifeblood of bank profitability, expanded in 2010 at the fastest year-over-year pace on record (see table below). At 3.72% exiting Q3, the last time net interest margins at U.S. banks were this high was 2003.
Year-over-Year NIM
YoY Change
The level of economic activity continues to trend higher with capacity utilization increasing similarly to periods exiting recession. (See chart below). As production lines are restarted, aging plants and equipment will be updated, and C-Level executives will be tasked with deciding if its better to use cheap financing or cash hordes for projects. Increasingly, CFOs will lock up cheap money before it disappears, recognizing cash can be deployed more effectively in the form of dividends, mergers & acquisitions or through investment. All this means loan volume growth for banks. And, despite economic activity resulting in tighter Fed policy, the volume growth – as it has historically – will produce far greater profits than are eroded by rising short-term rates. In short, the yield curve will remain steep enough to support significant profit upside on volume growth until short rates get to around 5%.
Loan growth won’t just come from industrials. Commercial lending will also begin to improve in 2011. Spending on hotels, resorts, office buildings and apartment building ground to a halt through the recession, and selectively, developers will begin to model for capacity expansion as rents and occupancy stabilize. Real estate tracking firm Reis reported that Q4 office vacancy rates had done just that – coming in essentially unchanged from Q3, and marking the first time the metric hasn’t moved higher since Q3 2007. Also in Q4, apartment vacancy rates moved below 7%, to 6.6%, according to Reis, for the first time in two years, marking a fourth consecutive quarter of improvement and helping to move rents higher.
Also important to recognize is that the rate of decline in commercial and industrial loans at all commercial banks has flattened and is set to turn higher, similar to this stage of the post-recession economic cycle. See the chart below and then consider the similarity to prior recessionary periods since the 1970’s. Clearly, if history rhymes, the banking industry is well situated for loan growth.
As for consumer lending, retail spending rose 5.5% over last year, according to Mastercard Advisor’s SpendingPulse, a positive sign consumers are feeling more secure in their jobs. The key to unlocking consumer lending, however, will remain overall job growth and trends remain positive for 2011 job creation. According to the American Staffing Association, staffing employment in December was 16% higher year-over-year. Historically, temporary employment has led private sector job creation by nine months, suggesting this year our economy will continue to create jobs as employers gain confidence and look to lock up temporary talent. In a January 6th appearance on CNBC, Manpower (NYSE:MAN) CEO Jeffrey Joerres, who knows a thing or two about employment cycles, said he expects small and mid sized job creation to join manufacturing job growth in 2011. As jobs return and incomes improve, consumer lending will pick up. In the meantime, default rates will continue to head lower. In December, S&P Experian reported first mortgage defaults fell 38.6% from last year, second mortgage defaults fell 51%, bankcard defaults fell 17.7% and auto loan defaults dropped 36.8%.
If the scenario we’re outlining holds true (and we believe it will) those who own banks will be rewarded nicely in 2011 as the media conversation switches to loan growth from reserve releases. And, in case you were interested, financials were a top performer in 2005, the second full year following the 2003 bear market low. If the economic cycle is alive and well, financials will be the place to be this year.

Disclosure: I am long USB, NTRS, STI, ZION, FITB, PNC, KEY, JPM, WFC.