Sunday, April 22, 2018

Guest Post: Financial Markets and Economic Update by Dorothy Jaworski

The Long Winter
I’m writing this in April, during the winter that is taking forever to end.  We braved the cold of December and January, were teased with some warm days in February, and then found ourselves in March, with its four nor’easters, cursing the snow each week and shivering in the cold.  We have had quite enough!  And I’ve said it before, that snow covered roads and potholes destroy productivity.  I’m sure we won’t get much sympathy from places like Chicago, Buffalo, and Erie, but they signed up for winters like this, not us here in Philly.  Only one thing made winter bearable this year- the fact that the Eagles won Super Bowl LII and the celebrations began.  Now, if Mother Nature would cooperate…

The markets have been incredibly volatile in the first quarter of 2018.  This may be the understatement of the year!  The spike in volatility was a wake-up call to every investor and market participant that thought “vols” would stay historically low forever.  Welcome to 2018!  Stocks, bonds, and commodities spike up and down in large percentage changes almost daily, leaving investors wondering what is next.  Nearly everyone expects periodic market corrections, but no one expected to have whiplash!

What prompted volatility to rise so much?  The first sign that markets were about to be rocked was an inflation scare concerning wages in early February.  Wage growth was reported at +2.9% on a year-over-year basis.  Wow!  The Federal Reserve thinks unemployment is too low, which could lead to higher wages and inflation, and they are raising rates.  Aren’t they proven right?  Stocks fell dramatically, rose, fell, rose, fell, rose, well, you get the idea.  Hundreds of points in price changes in the Dow Jones Industrial Average got headlines every day.  Several unusual hedge funds that were based on market volatility levels collapsed, most notably funds from Nomura and Credit Suisse, leading to 90% losses for those “investors.”  Who even knew they were there? 

Alas, inflation was not to be- not yet, anyway.  The year-over-year wage growth fell back in March and April to +2.6% to +2.7%, closer to where it had been in 2017.  This only gives proof that the Fed is still looking at the Phillips Curve (unemployment-inflation tradeoff) to set policy.  During March, we also had the opportunity to see new Fed Chairman, Jerome Powell, in action.  He gave a press conference and was confident and concise.  He is a man with financial markets experience and should understand the effect of Fed policy on the markets.  His recent predecessors were academics.  During March, 2018, Powell and the Fed increased rates by .25% for the sixth time since December, 2015.  Chairman Powell reiterated continued slow and steady rate increases.  At some point, and I believe soon, the Fed will pause.

Tech stocks added to the volatile environment during the past few months.  Facebook continues to be whipsawed and other major names like Google, Amazon, Netflix, and Microsoft fell in sympathy with their social media favorite.  Volatility continued when the Trump Administration announced tariffs on steel and aluminum imports, mostly directed at China, who responded in kind by slapping tariffs on 125 products exported by the US.  The markets hate the idea of tariffs and the trade wars that can be a result and the market price action reflects it. 

The Economy
All indications are that the economy will continue to improve, albeit slowly and at a lesser pace than that of previous recoveries.  Tax cuts are adding stimulus and leading to improved business and consumer optimism, but there are some offsetting factors in the form of Fed tightening, low productivity, and large levels of debt, especially at the federal government as they fund what could be a $1 trillion plus deficit this fiscal year.  Fourth quarter GDP was +2.9% and was +2.3% for all of 2017.  In March, 2018, the Fed revised their GDP forecast for all of 2018 to +2.7%, which is hardly worth writing home about compared to growth in 2017, but is still at a level that I consider to be sustained.  When GDP growth is stuck in the 2s and overall inflation is around the Fed target of 2%, raising interest rates too much can lead to an unhappy ending.  Not only are short term rates rising, but long term ones did, too, in response to the inflation scare and the Fed unwinding some of their balance sheet investments.

Housing, construction, and the auto industry are projected to do well in 2018, as long as rates do not rise too much or too rapidly.  Don’t get me wrong, the US economy is doing well, given the environment and volatility and is expected to outperform Europe and Japan.  Consumer spending and retail sales have shown weakness since the fourth quarter of 2017 but we should see improvement.  Gas prices remain below $3.00 per gallon, adding to a positive consumer spending outlook; let’s hope prices do not rise too much into the summer travel season.  Businesses should do well as they bask in the lower corporate tax rate, which fell from 35% to 21% at the beginning of 2018.

National housing indices continue to rise by +6% on a year-over-year basis and are projected to rise at least +5% during 2018, provided that long term mortgage rates do not spike and cut off demand.  Locally, Bucks County has seen its best year-over-year increases in the last two quarters of 2017, rising +5% and +6%.  One factor that is impacting prices is limited supply compared to prior years.  In many cases, inventories of unsold homes represent three to four months’ worth of sales, compared to a more normal level of six months. 

The Federal Reserve Beige Book is released in advance of the Federal Reserve meetings.  The recent March, 2018 report for our Philadelphia Region was overall quite positive; the words “modest” or “moderately” were used 16 times on two pages.  The implication is that the economy here is okay and still growing.  The Philadelphia Fed’s Business Outlook survey confirms this, with most of the survey results positive.  And most of all, it is a great time to be a Philadelphia sports fan!  The Eagles won the Super Bowl, bringing joy to fans who were experiencing their first Super Bowl win for their city in their lifetimes.  Villanova won the NCAA title again, the Sixers just completed a 16 game winning streak to end the regular season and have made the playoffs, the Phillies have been hitting lots of grand slams and show promise, and the Flyers made the playoffs, however faltering in their first game but it is a long series, as they say… 

Thanks for reading!  DJ 04/12/18

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 Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, 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 of devotion.

Thursday, April 12, 2018

Consumer Lending: Should Banks Do It?

We’re running out of assets.

When I first read Standards Needed for Safe, Small Installment Loans from Banks, Credit Unions by the Pew Charitable Trusts that encouraged financial institutions to get back into small ticket consumer lending, I thought “what are they nuts!”

Consumer loans for those banks that utilize my firm’s outsourced profitability reporting service lost (0.26%) as a percent of the average consumer loan portfolio in the fourth quarter. And it wasn’t an anomaly. Ever since we formed our company in 2001, this has been the case.

Sure, home equity lines of credit made 0.71% for the fourth quarter. But it was the only sub-product that showed a profit. Fixed home equity loans… nope. Indirect loans, unsecured personal loans? No and no. So why would banks expand small-ticket, unsecured personal lending?

Because we’re running out of assets. Pretty soon we’ll be left with small to mid-sized business loans and commercial real estate that isn't big enough for large banks or conduits. And there are FinTechs, loan brokers, insurance companies, and investment funds chipping away at them.

Mortgage lending is getting away from us. Mortgage bankers and brokers own a significant share of market (although less than prior to the 2007-08 financial crisis). And Quicken Loans is in the top 5 HMDA market share in nearly every market we analyze. Oh, and Quicken is hammering away at home equity lending too.

We lost auto loans to the indirect market. Who comes to our branch for a car loan today? If we don’t consider how we intend to defend our small business and CRE lending, and re-enter some of these other loan markets, we may end up as a balance sheet for hire. Which we already do via buying mortgage back securities and using loan brokers in metro areas.

Are you ready to be Web Bank, part deux?

So I reconsidered my knee-jerk reaction to the Pew Charitable Trusts report. Most community financial institution strategies has some sort of “community” focus. It’s implied whenever someone says “we’re a community bank”. Which nearly everyone does. Even the big banks. So maybe we should put some moxy behind those words. Profitable moxy, though. Not charitable moxy.

Why do consumer loans consistently lose money? Looking at our peer group numbers, the consumer loan costs a little above $1,100 per year in operating expense to originate and maintain. Expensive. This is a fully absorbed number. Meaning that all bank resources that are dedicated to the consumer loan function is fully allocated to the product, whether they are being used or not. And recently, they have not been used.

For example, there is a fair amount of branch expense in that number, because branches are typically responsible for originating those loans, and participate in their maintenance. If we got rid of consumer loans, that expense would migrate elsewhere. And if we are not originating new loans, then resources dedicated to origination, such as branch staff and credit, for example, are dormant but must be paid for by the existing loans in the portfolio.

Four Ways to Bring Back Consumer Loans, Drive Volume, and Increase Profits

1.  Make consumer loans more than an accommodation. Not many financial institutions consider consumer loans as a strategically important product group that will drive growth and profitability into the future. Perhaps it is because of the hurdles to achieving meaningful growth and market share. Or the competitors that wedged themselves into the dominant market position. But if executive management and the Board aren't committed to pursuing consumer lending to be more prominent on your balance sheet, then you will not succeed.

2. Align your credit culture and risk appetite to be successful consumer lenders. It is not lost on me that the last bastion of consumer lending at banks is home equity loans. Real estate secured. Hard collateral. Relatively low charge-offs. It is difficult to change that mindset when doing loans with little to no collateral, such as small ticket consumer or credit cards. Charge-off rates of 4%-5% with no collateral? Yes. Get used to it (other than home equity). Or don't do it.

3. Drive down costs. Regulation has driven up costs and made us gun shy. But we can't continue to put $1,100 of resources per year into a consumer loan. Especially if the loan balance is $2,500. How can we possibly make money on that? We can't. The ABA recently conducted a survey on the State of Digital Lending (see chart) that said that, although consumers were happy with how smooth and quick online lending decisions were made, online lenders only received a 26% approval rating, versus 75% for banks. Driving more volume will drive down costs by putting under-utilized resources to work, and digitizing end-to-end will reduce the amount of resources needed for consumer lending. 

4. Price right. Even if banks cut the cost of originating and maintaining consumer loans in half, to $550, what rate will they have to charge to make a reasonable profit? Let's say a reasonable profit is a 1.5% pre-tax profit as a percent of the portfolio. And the non-home equity portion experienced a 4.5% charge-off rate. And the cost of funds for such lending is 1%. If the average loan size was, say, $3,000, the bank would have to charge an effective yield of 25.3% (($550/3,000)+1%+4.5%+1.5%). Those rates get the scrutiny of do-gooders and "champions of the people" that could cause negative press. And keeps community financial institutions out of this business. Take note Pew Charitable Trusts. However, knowing this math, the bank can work at pressing the levers needed to do this lending profitably, at the right price, that benefits borrowers and the banks. And keeps those borrowers out of the hands of the sharks that prey on their misfortune.

Should we give up on consumer lending?

~ Jeff