Sunday, July 27, 2014

Guest Post: Second Quarter Economic Review by Dorothy Jaworski

Summer’s Here
We are all thankful that summer has arrived!  Heat and humidity!  And no one complains!  After the brutally cold and stormy winter, stuck in the perpetual polar vortex, no one dares to complain.

Our winter mood was brutally apparent in the GDP report that was released for the first quarter of 2014.
Actually the report comes out three times with a preliminary report, a revision, and a final report.  The Bureau of Economic Analysis, or “BEA,” a part of the Commerce Department provided their preliminary peak at 1Q GDP at the end of April.  GDP was reported at -.1%, they said.  Hey, great!  That winter wasn’t so bad after all…The second release at the end of May came in at -1.0%.  Wait!  That winter was bad.  Business just didn’t replenish inventories…Then came the shocking final report at the end of June showing -2.9%!  Wait!  The economy was so bad, the weather was so bad, consumers did not spend…

This is supposed to be an economic recovery.  In fact, it is now five years old.  And we get a terrible quarter like that?  What is going on here?  I will tell you that the change from -1.0% to -2.9% by the BEA was the largest downward revision since this GDP methodology was developed in 1976.  And do some math- if GDP grows at 3% (by some miracle) for the rest of 2014, GDP will average 1.5% for the year!  Plenty of excuses accompanied the final report, but I am not completely buying them.  I sum up the revisions by the BEA with a thought from Mike Flynn (06/30/14):  “If you torture economic statistics long enough, they will confess to anything.”

What’s Really Going On
I am still of the view that our economy will continue its growth path at 2% to 2.5%, well under its normal recovery speed and well below its potential.  Numerous regulations burdening all industries and higher capital requirements for the banking industry will weigh down growth.  Investors’ Business Daily has estimated the annual cost of regulation at $1.86 trillion.  Just think about that number as it relates to $17 trillion in annual GDP.  Consumer spending tanked in 1Q14, but should rebound in 2Q14.  Remember the spike in electricity prices in January and February?  That put consumers in a bad spending mood.  Gas prices began a slow climb in 1Q14 and the increases have not yet abated.  Gas prices have passed $3.70 per gallon and are up 12% year-to-date.  I’m outraged, aren’t you?

Having just read an article on Bloomberg that the US has now surpassed Saudi Arabia and Russia with average daily output of 11 million barrels of oil in 1Q14, I would have thought that the concepts of supply and demand were still alive.  Due to the fracking boom (extracting energy from shale rock by using high pressure liquid to split rocks and release oil or gas) has made the US competitive in the energy industry again and there is little impact to reduce our prices?  That leaves me outraged!  Will we approach our all time high gas prices of $4.11 per gallon from July, 2008 and $3.99 in May, 2011 soon?  At both of those times, consumers reached a tipping point where spending fell on most discretionary goods as a result.

Employment
Recent employment reports have been increasingly positive, showing the potential for GDP improvement. The June report showed that 288,000 jobs were created.  The unemployment rate fell to 6.1% in June from 7.5% one year earlier.  Many of the jobs being created are low paying ones or are part-time.  The proportion of part-time jobs to total jobs is now at 19% compared to 17% in 2008.  People dropping out of the labor force have certainly contributed to a falling unemployment rate; Those Not in the Labor Force rose again in June to a record 92.1 million.  The labor force participation rate is still at a 30 year low at 62.8%. These two statistics speak volumes- we are losing the productivity of a great number of persons, probably very experienced ones.

To know if interest rates will rise soon, or sooner than the market expects, my advice would be to watch the Yellen Dashboard on employment and pay attention to whether the measures are improving over pre-crisis ones.  The markets expect the first short term rate increase in mid-2015 and this is built into the futures markets.  The Fed has already indicated that they will be ending the QE program by the fall of 2014.  It is my view that the program initially worked, but in 2013, the Fed lost credibility with it and had to begin to unwind it.  And, as always, watch inflation, too.  It is still tame and at or below Fed targets.

The Economy
Yes, our economy is resilient, but five years into a recovery, growth of about 2% is well under our potential. Since the recovery began in June, 2009, real GDP has averaged +2.2%.  In the ten previous recessions, real GDP averaged +4.6%.  I do think we will continue to grow around 2%.  Hiring is up, albeit with lots of part-time jobs.  Average hourly earnings are up to $24.45, which is an increase of 2% in the past year. Consumer spending may not be much higher than 2% as borrowing to supplement spending is not as prevalent as it was before the 2008 crisis.  Technology is advancing and aiding productivity growth.  Stock markets are reaching new highs with the Dow Jones average at 17,000 and the S&P 500 approaching 2,000, with a PE ratio of 15.7 times.

We would love to grow exports but Europe and Asia’s economies are fairly weak.  I may have to personally go to Europe and investigate!  The European Central Bank, or “ECB,” just lowered rates again and this time tested negative interest rates, at -.10%, on bank reserve deposits.  Speaking of other parts of the world, the unrest and fighting in Iraq, Syria, Israel, and over in the Ukraine make for a very uncertain world indeed.  In the US, children and immigrants from South America are flooding through our borders in huge unmanageable numbers.  Uncertainty is often the enemy of economic growth.

As always, take heed of the roadblocks to higher growth (the Fed calls them headwinds) - high gas prices, regulatory burden, weak world economies, low income growth, uncertainty, and bad pothole repair!  Stay tuned!


Thanks for reading and Happy Summer!  DJ 07/09/14


Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004. She is the author of Just Another Good Soldier, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure.

Monday, July 21, 2014

Will Bigger Lead to a More Efficient Bank?

A friendly competitor of ours, Anita Newcomb, spoke about strategic planning and economies of scale in banking at the recent Maryland Bankers Association annual convention. She led attendees through the increasing regulatory burden and the need for some level of scale to remain competitive.

This got me thinking, if Anita's premise is correct, that bigger is necessary to compete, then what is bigger? And what has changed since before the dawn of Dodd-Frank? So I went to the numbers. As I have often said, it always comes down to a spreadsheet.

I searched for all banks and thrifts that have existed since at least 2007. Any institution that had "NA" in their efficiency ratio for either 2007 or year to date (YTD) 2014 I eliminated. So the sample size was fairly large, nearly all financial institutions in existence today. I then parsed them into seven asset size categories, and compared their efficiency ratios in 2007 and today. The result is the below tables.



For both periods, the lowest efficiency ratios come from the $20B - $100B asset class. In 2007, this asset class had 60% of their members achieve an efficiency ratio lower than 55%. That number has shrunk from 60% to 30% YTD, a dramatic fall from glory. Yet the asset class retains the honor of the highest percent of banks that achieve the under 55% honor.

All asset classes suffered declines in the percent that have efficiency ratios lower than 55%. In 2007, however, you can see the steep dropoff in efficiency between the $500MM - $1B and the $1B - $5B classes. In 2014, the dropoff moved upstream to the larger banks, with 24% of the $5B - $10B banks achieving < 55%, and the $1B - $5B asset class only having 15% under 55%.

So, at least statistically, it appears as though it is becoming more difficult for banks with less than $5B in assets to achieve superior efficiency.  But it is difficult for everybody, not just the under $5B class.

One of my working theories regarding the "you must be bigger" argument was that the number of smaller institutions that achieve superior efficiency is shrinking. So the anecdotes about how this small bank or that small bank do it (achieve superior efficiency) are declining. But the anecdotes about all banks achieving superior efficiency are also in decline, according to the statistics.

Even though only 11% of banks with less than $500MM in assets achieve a sub 55% efficiency ratio, it still represents the greatest amount of banks that achieve the feat. So, if you are sitting around your Board table or in senior management meetings lamenting about rising costs relating to regulation and technology, perhaps instead of calling your investment banker, you should ask how the 11% of small financial institutions do it.

It's a legitimate question, right?

~ Jeff