U.S. Banking Sector Still Not Out Of The Woods

by: Disruptive Investor

In one of my recent articles, I had discussed the relative attractiveness of the U.S. banking sector when compared to the banking sector in Europe and Japan. In this article, I will discuss the reasons why the U.S. banking sector (standalone) is still not out of the woods.

Before that, I would like to mention that the financial sector in the United States will present attractive medium-term trading opportunities (whenever the sentiments get too bearish). However, over the long-term, the financial sector will continue to shrink after the massive expansion witnessed in the last decade.

From an investment perspective, a stock like JPMorgan Chase & Co. (JPM) can be considered for long-term by investors willing to have financial stocks in their portfolio. JPM does offer an attractive dividend yield of 3.3% and falls under the too big to fail category.

Coming to the main discussion point, below are the major reasons why the U.S. banking sector is still not out of the woods.

The process of deleveraging for the household sector is one of the most important reasons for being skeptical about the long-term health of the banking system. The total household debt in the United States has been declining since the fourth quarter of 2008. The total household debt outstanding has declined to USD11.4 trillion in the first quarter of 2012 from USD12.7 trillion in the fourth quarter of 2008.

Total Household Debt Outstanding as of 1Q12Click to enlarge

With the core banking activity being interest income, the deleveraging coupled with high delinquencies will continue to impact the income and profitability of banks in a weak economy and a weak job market. The depressed consumer credit growth underscores the point I am trying to make.

A high percentage of seriously delinquent loans give another reason to remain cautious on the banking sector. The total amount of seriously delinquent loans (90+ days) as of first quarter of 2012 was USD796 billion and the total delinquent loans were USD1.06 trillion.

90 plus days household delinquent loans as of 1Q12Click to enlarge

If the US banks were to write off the seriously delinquent loans, the banking system will be staring at huge losses in the foreseeable future. To add to the woes, the real unemployment scenario has hardly improved in the United States as discussed in one of my earlier articles. Higher level of unemployment and longer duration of unemployment might keep seriously delinquent loans at elevated levels.

Also, when talking about the potential challenges for the banking sector, the growth in student loans deserves a mention. The total student loan has ballooned to USD904 billion as of 1Q12 and is the only category of household loan, which has increased after the financial crisis.

Student loan outstanding and delinquency rateClick to enlarge

In my opinion, higher unemployment (especially among the youth) will lead to higher delinquencies in the future for student loans. In 1Q12, the percentage of 90+ days delinquent student loans has gone up to 8.69% from 8.45% in 4Q11. The student loan can be potentially a USD1 trillion ticking time bomb for the US banking sector.

Besides the negatives arising from concerns related to the economy, the U.S. banking sector is also exposed to the Euro zone crisis through derivative linkages. If the sovereign debt crisis worsens in Europe, tremors will be felt in the U.S. banking sector.

The financial crisis has lead to some irreparable cracks in the banking system. However, with some support from the government, U.S. banks have managed to exhibit some turnaround and stability. The coming few years will be critical and challenging for the banking system with sluggish credit and economic growth coupled with the probability of significant losses.

As mentioned above, investors will have ample trading opportunities in the banking sector with sentiments swinging wildly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.