What to watch out for in banks’ earnings reports

Unpacking consumer trends, corporate prospects and emerging asset quality challenges

David Wilkinson - Senior Fixed Income Analyst

The US banking sector will report their third quarter earnings from this Friday providing crucial updates on the health of the US consumer, prospects for US corporations, and potential paths for the economy and monetary policy. The message from last quarter (Q2 2024) was very consistent - a strong economy, with perhaps some fraying around the edges. Rising unemployment, high rates and elevated inflation were causing headwinds for some consumers. For this quarter we will be on the lookout for asset quality indicators in credit cards and commercial real estate.

Increased credit card spending and borrowing - a key indicator of US economic health?

While loan growth overall has been supressed by higher rates, credit card lending has continued to grow strongly. Federal Deposit Insurance Corporation (FDIC) data shows that since the first quarter of 2021, US banks’ credit card loans have grown by 45%, equivalent to 12% a yearⁱ, compared to total loans which have grown at 4.5% per yearⁱⁱ. This increase in borrowing has likely contributed to the strong consumer-led recovery in the US, but it poses two key questions; is this trend sustainable, and does it store up asset quality problems for the banks in future?

There seems to be some runway for consumer borrowing to continue to grow, albeit at a slower pace. Bank of America's credit card book utilisation rate, the proportion of total available credit borrowers were using, was flat in the second quarter and remains below 2019 levelsⁱⁱⁱ. As rates start to come down, Home Equity Lines of Credit (HELOC) lending has also started to tick up as consumers look to borrow further against the value of their property without having to refinance mortgages that have been locked in at low rates. It seems this debt-funded boost to the economy is not totally disappearing any time soon.

Third quarter results will be watched closely for signs of asset quality deterioration, including trends in the level of net charge offs, the amounts the banks consider unlikely to ever be repaid. Net charge offs on credit card loans are rising but not high on a historical basis. JP Morgan, the largest credit card lender in the US, reported a net charge off rate of 3.5%^iv on credit cards in the second quarter, compared to 2.41% the prior year, but a long way off the peak of 10.5% in 2010^v.

Further losses ahead in commercial real estate?

Another sector under the microscope is US commercial real estate (CRE), in particular office property. Post-pandemic trends in remote and hybrid working reduce demand for office space at the same time as higher interest rates makes refinancing more costly and property prices decline. Asset quality among the banks' CRE portfolios has already deteriorated. As of the second quarter Wells Fargo had $30bn of real estate lending secured on office properties, 12% of which were classified as non-accrual, having not made loan payments for over 90 days^vi.

Those US banks most exposed to US commercial real estate have already taken material provisions against potential future losses, for several institutions around 10% of the total loan balance. The third quarter should show if these existing provisions are enough to absorb the losses now that US rates have started to decline.

Sectors views

By all metrics it appears that asset quality risks in the US banking sector is contained. Investors can take additional comfort in the deep capital buffers maintained by the banks and overseen by the regulators. To the extent that risks will impact creditworthiness, we are more cautious on the US regional banks where commercial real estate exposure is proportionately greater, and where capital buffers are likely to narrow.

The regional banks do not offer significantly higher credit spreads compared to the US money centre banks, for bonds with similar duration and position in the capital structure. In the base case of a soft landing, it is likely that bank asset quality will remain robust across the board. But in the event of a sharper than expected downturn in the economy, potentially exacerbated by specific stresses in commercial real estate, credit spreads do not compensate investors for the additional risks.

ⁱ FDIC Quarterly Banking Profile, Q224 Vol 18

ⁱⁱ FDIC Quarterly Banking Profile, Q121 Vol 15

ⁱⁱⁱ Bank of America Q224 Earnings Presentation, 16 July. Slide 5.

^ivJPM Q224 Earnings Presentation, 12 July. Slide 4

^vJPM Q110 Earnings Presentation, 14 April. Slide 7

^vi Wells Fargo Q224 Earnings Presentation, July 12. Slide 9

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