Investors on edge over credit cracks in Q3 bank earnings reports

Call it normalization or the start of a credit cycle, credit metrics are slipping and investors appear queasy about how badly performance could deteriorate.

Consensus estimates anticipate that ratios of nonperforming assets (NPAs) will tick higher by a median 3 basis points sequentially at the 25 largest publicly traded banks in earnings reports for the third quarter, according to data from S&P Global Market Intelligence. Estimates forecast a median increase of 4 basis points in ratios of net charge-offs (NCOs) to average loans.

That would represent modest worsening, and US bank credit performance broadly remains better than pre-pandemic norms, supported by strength in employment that continues to blow past forecasts.

After a long period of calm, however, sporadic cracks have the power to shake sentiment, and investors are focused on risks like a rapid increase in credit card borrowing, analysts said.

"Most investors have essentially no credit risk appetite at this point in the cycle," Raymond James analysts said in a note Oct. 5.

One-offs

On the commercial side, banks have already been girding for losses on loans backed by office buildings with substantial reserve builds.

Losses at a string of midsize banks tied to the bankruptcy of a wholesale oil distributor also serve as a reminder that a credit cycle could be broad.

"Historical loss rates for [commercial and industrial loans] are about twice as high as compared to CRE (76 basis points versus 39 basis points), which means investors need to be prepared for credit normalization across asset classes heading into 2024," Keefe Bruyette & Woods analysts said in a note Oct. 5. They said they "do not expect a material step-down in the credit outlook" in the third quarter.

"We see higher credit costs as a second key driver to reduced estimates" after lower net interest income, the Raymond James analysts said.

Consumer risks

On the consumer side, analysts at BofA Global Research expect credit card loan losses to continue to worsen, citing delinquency trends and rapid loan growth.

Card loan growth has moderated recently, however, and if the trend continues as anticipated, losses could peak around the middle of 2024 "and then should drift lower," the BofA Global Research analysts said in a Sept. 22 note. They also observed that expectations for a soft landing and strong labor markets "are positives that can dampen a more significant rise in credit costs in 2024."

Analysts at Jefferies said it is too early to call a pivot in credit trends for credit card borrowers with prime credit scores, noting that troubling factors are offset by signs of continued strength like high payment rates.

"If there is a turn for the worse, we believe the impacts would be modest given a healthy job market and resilient economy thus far into the cycle," they said in a note on Sept. 28. A "material credit cycle" would require "a jobs-based recession, with unemployment moving beyond the 5.5% to 6% range" that reserve levels already largely anticipate.