This is the second in a series of articles focusing on the macro implications of what is happening at the large banks, and what it means for them and the rest of us going forward. Links to other articles at the end.

Who Leads When They Dance?

QE is a dance, and the public perception of who leads is often far off from the truth. The US has capitalism, at least on the surface, which means two things for our discussion:

  • The Fed is a bank to banks. When they buy $2.4 trillion in Treasuries and MBSs in QE, it is from the banks.
  • Though heavily regulated, the banks decide what they do with it. What they have decided to do is hoard cash.

So now that the banks’ Q2 is in the books, let’s look at how it is playing out on the micro level, and what it means for us and the banks going forward. We already looked at JPMorgan (JPM), and next up is Bank of America (BAC).

The Macro

If you read other installments, this section will all be familiar to you, so feel free to skip.

I’ve been covering the dance pretty extensively here at Seeking Alpha since September of 2019 when Not QE began. The main actors are the Fed, the Treasury, and the banks.

The point of the current QE Infinity regime was to drop a bomb of liquidity on the banks to make sure they were ready for whatever was coming, not just now, but over the next several quarters. But from the last go around, the Fed knew that the banks are not always the best transmission belts for policy in a crisis, which is why we get the facilities, but more importantly the CARES Act with the Paycheck Protection Program (PPP) loans, and Pandemic Unemployment Assistance (PUA) payments.

So, the Fed is throwing cash at the banks in 3 ways:

  1. By far the largest is QE, where they buy Treasuries and MBSs from the banks at par. That is now at $2.4 trillion since the March 11 balance sheet, but at $2.3 trillion at the end of June when the quarter ended.
  2. The repo facility came first, a week before QE started. That ran up quickly to $422 billion, but QE has made it superfluous. It was down to $61 billion at the end of June, and $0 now.
  3. Finally are the different loans and facilities. These were announced with giant limits. But they have all been very modest, now totaling only $210 billion, $214 billion at the end of June.

But at the same time, the Treasury has been grabbing with both hands, as revenue and debt sales have far exceeded spending and debt repayment. Since March 11, the Treasury’s account is up $1.4 trillion, $1.3 trillion at the end of June. Even the Treasury is hoarding cash.

This is what that all looks like on a chart through the end of June.

So that’s what the combination of the Fed and the Treasury has been doing to bank reserves. What have the banks done? Yes, hoard it.

The green column is the net of the previous chart.

As you can see, bank reserves have surged to record levels, though they are off from their peak as QE slowed, but the Treasury kept grabbing with both hands. But the point here is that the blue bar, the change in reserves, remains more than what is being thrown at them by the Fed.

That is because via PPP and PUA, the Treasury is not only hoarding cash but throwing it around pretty generously. The banks have held on to every dime of the Fed’s money because household and corporate deposits have soared and there is a giant savings glut.

There are other private actors besides the banks, and they are much more consequential. This includes corporations, but most notably households. Household balance sheets are undergoing the most dramatic shift ever.

Versus in the coming TTM average in February, cumulatively through May, households:

  • Earned $206 billion less;
  • But received an additional $453 billion in benefits, for a net of $247 billion in additional income.
  • Moreover, households consumed $398 billion less;
  • And also paid $59 billion less in taxes.
  • Consequently, there is a savings bubble of $693 billion;
  • Of which consumers used $99 billion to pay down credit card balances.

So, when we’re frisking the banks’ quarters we are looking for:

  • Giant buildup of loss provisions – the reserves.
  • Very little lending outside of what has been guaranteed by the Fed through PPP. The banks are not that interested in risk.
  • Credit card balances and traffic declining.
  • Dramatic increases in non-performing loans.
  • An even more dramatic increase in savings and checking balances.

The Micro: Loan Losses and Provisions

A recurring theme in the earnings call was Bank of America’s “fortress balance sheet.” What they are referring to:

  • They have had the lowest loss margins of any of the big banks in 7 out of the last 8 stress tests.
  • They claim to have gone over every commercial loan in their book over the last two quarters to reassess the risk of each one.
  • They have not gotten out over their skis in any one area like they did the last go-around with commercial real estate construction loans.
  • They think their risk-management procedures are far and away better than they were in 2007. That is a low bar, but let’s hope it’s true.

The big headline for all the banks is that they have deferred payments amounting to many billions for consumers, so it’s very hard to tell what the true losses are going to look like once that savings bubble settles. For example, home loan non-performers rose 7% from December to June to $2.1 billion, but there are another $15.7 billion in deferrals there. Credit card balances past 90 days due were actually down 25% to $782 million, but there are $7.6 billion in deferrals here.

On the commercial side, they have already seen bad loans climb 47% or $703 million. Almost half of that came from outside the US. But they also have giant deferrals here of $3.5 billion to small businesses.

Adding up all the deferrals, there is a very rough potential here:

That little blue box at the bottom is what’s bad now, and you see how giant the deferrals are in relation. All the banks have a similar sort of situation. What happens with these deferrals is crucial once the banks end forbearance.

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But so far, Bank of America’s loans are performing better than their peers, so there may be something to their “fortress balance sheet” talk.

When we look at what they’ve reserved, it’s a lot.

They also have another $28 billion in extra CET1 capital as backup. Like JPMorgan, their reserves have reserves.

But the interesting thing is that, not counting the backup reserves, they have reserved much less proportionally than has JPMorgan:

Some context here regarding consumer cards and why the reserves are so high that they get their own axis. Consumer card defaults involve very little recovery. The reason rates are high is because banks wind up eating most every dollar on defaults. On the other end of the spectrum are home loans, which are secured by real estate. When residential real estate is on the rise, banks actually wind up making a small profit on the default, which is one of the reasons they like mortgages so much, and also one of the factors that led to the GFC.

Checking in on that:

The Case-Shiller home price index only goes through April, but the growth rate was still rising, at 4.7% YoY. This could change very quickly, but may be the beginning of a long-term trend out of central cities and nest feathering. It is way too early to tell.

But the point is, under this sort of environment, Bank of America can keep their home loan reserves very low, at 0.3% of assets. If the environment changes, they will likely have to add more to that, and will hamper their income statement down the road. They seem to be pretty confident in their home loan portfolio, their risk-management procedures, and also the portfolio in their Global Wealth and Investment Management division (GWIM), and their high net worth clients.

Autos and commercial loans also involve larger recoveries than credit cards, but not as high as residential mortgages, so reserve levels are higher than home, but still lower than cards.

But the point is Bank of America seems pretty confident, even though their outlook for the macro future is as grim as JPMorgan’s.

Earnings calls are primarily marketing events where corporate leadership put the best gloss they can on results to impress investors. This quarter we got some pretty blunt talk from the bank CEOs mixed in with their PowerPoint slides, even in the prepared remarks. Jamie Dimon of JPMorgan really stressed the level of uncertainty right now, and cautioned “we’re wasting our time guessing.”

Bank of America CEO Brian Moynihan led his presentation with a grim base case.

Baseline projections now extend the length of the recessionary environment into 2022 deep into 2022…

At present, core operating assumptions for making our credit projections and our reserving by the unemployment stays elevated and ends this year at around 10%. And it remains at 9% in the first half of 2021 and 7.5% at the end of 2021.

In that provision setting scenario mix, it takes some time until late 2022 or early 2023 for the aggregate GDP level to get to the same size, it was heading into 2020. So it will be a bit of work to get out — to get back to that level.

This is their base case, an 18-month slog back to zero. It also means they have two worse scenarios. Another interesting contrast is that Moynihan spent more time talking about the base case, whereas Dimon was more concerned with the worst-case, and whether it may even get worse than that.

Loan Levels and New Loans

The biggest hit to the assets side of bank balance sheets was the $125 billion in credit card balance reductions from December, and it turns out $13 billion, or 11% of that was from Bank of America cards. That’s a huge loss to their net interest income.

On the commercial side, we saw all the banks had a surge in commercial loans as revolver utilization hit records in Q1. At Bank of America, utilization went from 60% in December to 67% in March. But the combination of PPP loans for smaller firms and public markets for larger firms saw companies find longer and better terms, and that came down to 62% by June.

But total commercial loan commitments were down in H1 by 3%, excluding the risk-free PPP loans.

Absent guarantees from the SBA, they are not interested in taking on a lot more risk.

On the home lending side, some increased levels from before the crisis have come back in June. Bank of America’s home lending is now flat with December, though they increased their exposure to the residential market with $19 billion in MBSs. This becomes part of their capital, unlike the unbundled loans.

But we do see very high originations in the June quarter, especially among their high-income clients at GWIM.

So the simple math is that they are not taking on a lot of new risk here. Bank of America originated $49 billion in new home loans in H1, but their overall home loan levels rose only $2 billion, so most of that was either refi for existing customers, or mortgages they quickly turned around and sold off.

The fun part is that some portion of the loans they sold off were bundled by Fannie (OTC:FDDXD) and Freddie (OTCQB:FMCC), and then purchased back by Bank of America so they could have more AAA in their capital.

The Savings Bubble

The biggest feature of the economy right now is liquidity in all sectors – a giant savings bubble. Bank of America gives us a great window into this, and some added context from GWIM with their high-income customers. GWIM has $2.9 trillion in assets, $479 billion of it at their private bank. Between the two divisions, deposits were up $120 billion in H1, or 12%. Deposits at the consumer bank were up a little more proportionally, with checking leading the way.

But the phenomenon was global:

Overall, that’s a quarter trillion dollars in extra savings, and as we will see, Bank of America held on to every dime.

But an interesting divergence shows up between consumer and GWIM investment accounts. The consumer division is much smaller, but was up modestly by 3%, or $6 billion. But at GWIM, customers reduced their brokerage and assets under management by a total of $147 billion or 6%. This certainly lends credence to the theory that the current rally is retail-fueled.

There is so much uncertainty that banks think their best bet with all this cash is to take the 0.1% IOER and see what the next day brings. I do not blame them.

Me, April 6

One trend we see across all the banks, and indeed almost every sector, is a general unwillingness to stick their necks out in the crisis. This quote from the earnings call from CFO Paul Donofrio stood out to me:

We’ve added $284 billion in deposits since year-end. All of that has gone into cash earning 10 basis points. So as we assess the future of this pandemic, as we kind of assess how much of that is going to stick around and we get a little bit more confident on the — on those two elements that can be deployed into securities or a portion of it, let’s say, can be deployed into securities.

Donofrio is touching on two of our macro trends right here – the giant savings bubble and the huge increase of bank reserves at the Fed. When he refers to 10 basis points, he is talking about getting the IOER, the rate the Fed pays banks for excess reserves. That could have been in 3-month T-bills, averaging 14.2 basis points. They gave up something like $30 million in “risk-free” net interest income, because a 3-month time horizon was too long. That’s what uncertainty looks like.

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We also get a good look at declining consumption – $400 billion less from Feb-May in the macro – from consumer card volumes.

While debit purchases were down 4% in H1, credit card purchases were down 27%. Consumers do not want to tempt themselves into letting balances roll. Low volume and big paybacks lead to this:

Like I said up top, this is a big hit to net interest income.

Some Business from the Comments

Just a couple of quick notes here, because there was some discussion of these issues in the comments of the last article.

The first is that contrary to perception, the banks are making very little from the PPP loans. CFO Donofrio with the color here:

If you look at this quarter, there’s about a little under $100 million [in net interest income from PPP loans]. It will be a little more than that next quarter in NII for PPP. That’s a function of 1% interest rate plus under FAS 91, you’re going to amortize the fees into NII over the life of the loans.

In terms of the overall program, we’re — we did about 335,000 loans in a few weeks. That was quite expensive in terms of all that we had to do to do that well, and so I would not expect much if any profitability out of PPP…

Once there’s forbearance to the extent that we were amortizing those fees into NII, once a loan is forgiven then you have to accelerate the remaining fees that haven’t been amortized. So it could be a spike in a quarter or two if we start seeing a lot of forbearance.

The other thing is the issue of negative balance sheets that comes up. Reading a bank balance sheet is different from nonfinancials because deposits are a liability for banks, and are the lion’s share of their liabilities, especially now. Unlike nonfinancials, we mostly look for problem areas in the assets side of bank balance sheets, not liabilities.

The Upshot for Bank of America

The banks will be fine. If you have any takeaway from this section, it should be “the banks are absurdly liquid right now.” In contrast to the GFC, it’s the rest of us I am worried about.

Me, June 28

Despite their dour assessment of the economy, Bank of America executives exuded confidence on the call, and I don’t think they were bluffing. They think they are solid as a rock. CEO Moynihan from his scripted remarks:

When will the storm end? That is and has always been a health care question, not an economic one. So our job continues to be prepared for whatever the economic scenario ahead brings. And how do you get prepared? Well, it’s too late to start in the second quarter 2020.

We did that through our adamant team decade-long effort to drive responsible growth in our company. Portfolio is in great shape heading into this year. And in the second quarter, we reviewed our commercial loan portfolios at a customer level across our businesses.

Our risk ratings are up to date. We’re moving credit quickly to criticize our NPL designations. We’ve also gone through every credit to assess the needs that they’ll have to borrow in the near-term for liquidity and business prospects.

On our consumer books, we also benefit from the decade-long improvement in our underwriting standards. We remain consistent. And since the buyers’ surprising unemployment-related matters, we pared our consumer risk appetite.

A key difference in our company now versus the last crisis is the unsecured card portfolio is basically half of what it was going into the Great Recession and with better asset quality. Another example of difference is our commercial real estate, especially the far less exposure, especially in the construction area. We saw recent stress tests prove this out again, as we had the lowest losses in among the large firms. For the seventh of the eight past — for the seventh out of the eight — past eight stress test the Fed has run.

We’ve also improved our fortress balance sheet even from year-end to today, all this amidst this crisis. We have built liquidity.

This is not bluster; they believe it. But banks were also pretty confident about their risk management practices in 2006, and we know what happened after that.

The banks all have several bad quarters of net interest income coming. Term spreads are very low, and for everything else they do, their main business remains borrowing short and lending long to take advantage of these term spreads. They have been narrow or negative for a while now.

The boost they got from investment banking is a one-off, and they likely have large loan losses coming. So the question is, have they prepared enough for the storm?

The answer for JPMorgan is unequivocally yes, but it is less clear for Bank of America. They certainly have enough reserved for their now-deteriorated base case, but that does not include a second wave or natural disasters in the fall. There were also just a couple of giant earthquakes off the Alaskan and Canadian Pacific coasts. Two US carrier groups have arrived in the South China Sea amid heated tensions.

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Tail risk is enormous right now.

So if the base case goes sour in the coming quarters, Bank of America is going to have to keep adding to their reserves, which will further hamper their income statement. The good news is they have plenty of extra CET1 capital to fill that hole if necessary.

Uncertainty is so high, their reserves have their own reserves.

This All Worked Incredibly Well, But It Still Won’t Save Us

One of my top-line conclusions from seeing both the macro and now the banks’ micro is that all this policy worked incredibly well. The idea was that there was a long, hard storm coming, so prepare all sectors with a ton of liquidity to fight it off as it made landfall. Buy time to get the pandemic under control.

  • From QE and the facilities, we get banks with record levels of liquidity.
  • From PUA and UI, the Federal government filled the hole left by lost wages, and piled on another $250 billion to boot.
  • From PPP, small companies were able to get credit that would not have been available from the banks otherwise. We saw how they were able to pay down their revolvers and get accounts flush.
  • For larger companies, public markets were able to play the role of PPP, from all that liquidity in the other sectors.

We see evidence of that last bullet in Bank of America’s Global Markets division, where investment banking and market making revenues were up 33% in H1 YoY, and up 63% 2Q20 over 4Q19.

Q2 could have been a calamity much worse than the Great Depression. We could have seen an unprecedented wave of defaults, bankruptcies, evictions and foreclosures. That was staved off by timely action from the Fed, Congress, and the White House. For all the problems in these policies, and I am not trying to underplay them, the speed and size of relief were commendable, and everyone deserves credit for saving the world. I am not being flip when I say that.

CEO Moynihan touched on all this in his scripted remarks:

The central banks around the world led by actions of the Fed provided unprecedented liquidity in the financial system. The U.S. government has also provided direct payments through unemployment supplements EIP, the PPP program and many other things to help American citizens weather the storm.

Due to all that, the number of things are in fact different from our last quarter conversation. Panic borrowing has dissipated as it marks to provide a financing source for many companies to extend their maturities. Most companies have stabilized their operations.

Draw rates and middle market lines of credit are back to levels that they were mid last year. In the smaller business segment they are actually down as companies do not need the liquidity. But many companies may not like where they are in terms of revenue growth they have stabilized.

Consumers have benefited from direct stimulus and deferrals on loan payments from banks, such that delinquencies are far lower than what would be predicted in an 11% unemployment scenario. Consumers have more money in their accounts. For those that received the PPP, the small business that received it at Bank of America, we estimate that the money has been spent out of the PPP proceeds at only 35% level so far. So 65%’s left to be distributed from those companies to their employees and other vendors.

But what we bought with that $3 trillion was time, and that time was wasted. Instead of getting control of COVID-19, we let it get out of hand. This comes from a huge misconception that the shutdowns caused the recession, when it was the public health crisis that did. “When will the storm end? That is and has always been a health care question, not an economic one,” is what Moynihan told us. Since we never solved the public health crisis, we now have to shut down in many places again.

We see three trends in the “Bad Now” map:

  • The Sun Belt, especially the southeast, has a major problem on their hands.
  • Case rates are growing rapidly in the central US and mountain states. Just a few weeks ago, they were all blue. The same is true for the mid-Atlantic states and the Pacific northwest.
  • Case rates are now low in the northeast, but they have stopped falling.

Switching to the county map of where it’s getting worse:

Gray = insufficient data, mostly very small counties with 0 cases.

We see several of trends here:

  • Very few counties are seeing case rates come down.
  • Case rate growth in the Sun Belt is moderating, and has even started falling in Arizona, and maybe Louisiana, Florida and Georgia.
  • But the Mississippi-Missouri-Ohio River Valley population centers are a river of red.
  • We see pockets of red all over the mountain west and northwest.
  • The mid-Atlantic is heating up, and pockets of red are showing up in the northeast.
  • The problem has spread from cities to suburban, exurban and rural communities.

So what we are likely to see nationally is that case rates begin to come down in the short term, but then start rising again as the non-Sun Belt regions take over. Then comes fall and a possible second wave. Also, don’t forget about hurricane season in the east, and fire season out west.

So stop-and-start has gone from the middle-bad “adverse” case to the base case. CEO Moynihan:

Customers and businesses have adapted to a new environment. Some have reopened and yes some have also been reclosed or limited again. We expect this start-stop to be the base case as we look ahead.

Until there is a vaccine, best case in December, this is the norm.

Other Articles In The Series

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.