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North American Financial Institutions Monitor 4Q 2020: Finding Some Respite In The COVID-19 Storm


Despite Declining Loss Provisions, U.S. Banks Still Face Asset Quality Risks And Low Interest Rates


Hit To Mexican Nonbank Financial Institutions' Asset Quality Will Depend On Loan Portfolio Exposure By Sector


Earnings Among Large U.S. Banks Rebounded In Third Quarter, But Uncertainty Remains High


As The Pandemic Persists, U.S. Nonbank Lenders Will Likely Find Their Commercial Real Estate Assets Challenging

North American Financial Institutions Monitor 4Q 2020: Finding Some Respite In The COVID-19 Storm

Over the last few months, most financial institutions (FIs) in North America have entered somewhat calmer waters compared with earlier in the coronavirus pandemic--thanks largely to extraordinary government and central bank economic support and recovering markets. Signs of deterioration in most loan classes have slowed, funding markets have been open to most rated institutions, and early third-quarter earnings look much better than in the first half of the year.

Whether the calmer conditions last or prove to be the eye of the storm depends on a number of uncertain factors. Most notably, the duration and severity of the pandemic, the performance of the economy, and the effectiveness of further government stimulus will help determine whether financial institutions experience another wave of asset quality, funding, and earnings pressures.

Even in a more benign scenario, we expect FIs to see more asset quality problems, particularly in loan classes such as commercial real estate and leveraged loans, and relatively weak earnings. Most are unlikely to generate profitability at 2019 levels for at least a couple of years, with many banks hampered meaningfully by the ultralow interest rates weighing on net interest margins. Quarterly net interest income for some banks has fallen by 15%-20% over the last year.

The negative bias on our FI ratings in North America--with more than one-third of banks and nonbank financial institutions (NBFIs) each on negative outlooks--reflects those expectations as well as the high uncertainty.

Despite A Relatively Strong Third Quarter, The Economic Outlook Remains Uncertain

The U.S. economy appears to have performed better in the third quarter than many initially expected on the back of resilient consumer spending and a meaningful drop in unemployment. The unemployment rate fell to 7.9% in September, from almost 15% in April. S&P Global Ratings' economists revised their U.S. GDP forecast for 2020 to a contraction of 4.0% from the prior estimate of a 5.0% decline (see "The U.S. Economy Reboots, With Obstacles Ahead," Sept. 24, 2020).

Still, not all of the news is positive. As more states reopen, the number of COVID-19 cases per million population has started to rise again in the U.S., and real-time data is indicating a slowdown in the economy's recovery. Initial unemployment claims remain 4x the pre-pandemic level and job openings in cities are well below normal. There are also many permanent business closures.

While our economists have become more optimistic for 2020, they also revised down their expectations for 2021 growth to a more modest 3.9% from the previous 5.2% estimate. They do not expect the unemployment rate to reach its precrisis level until mid-2024.

The economy's performance and loan asset quality will depend, in part, on more government stimulus. Enhanced unemployment benefits and eviction protections have lapsed for many Americans. The stimulus provided to small- and medium-size businesses through the Paycheck Protection Program (PPP) has also ended. However, with elections looming, Congressional Democrats and Republicans and President Donald Trump have not agreed on an additional stimulus bill.

Our economists have assumed they will agree to a $500 billion package that includes emergency unemployment benefits, another round of the PPP, and funding for state and local governments. The results of the election and which party controls the presidency and Congress could have significant implications for a stimulus bill as Democrats generally want to extend more stimulus than Republicans.

However, if an agreement is not reached, the economy could perform worse than they expect, which will have implications for the asset quality of banks and NBFI lenders.

The Trend On Economic Risk In The U.S. Remains Negative

When assigning financial institution ratings, we take into account economic trends of the home country. As a result of the uncertain and challenging conditions in the U.S., in May we revised our expectation for the economic risk trend in the country to negative. The economic risk score is one of two factors in our Banking Industry Country Risk Assessment (BICRA), which helps us determine our anchor, or starting point, for our ratings on financial institutions.

Since the pandemic began, we have revised the outlooks on the ratings on more than 30 U.S. banks, either to negative from stable or to stable from positive. Many of those banks have had significant exposures to areas facing elevated pandemic-related stress, such as commercial (including energy), commercial real estate, and consumer lending.

The economic risk score of the U.S. BICRA is currently '3'. A negative trend indicates at least a one-third chance that we could revise it to '4' if the economy's rebound is weaker than we currently expect, causing a surge in loan losses for banks. A change to '4' would not lead us to change the current 'bbb+' anchor. Still, if we lowered the economic risk score to '4', this would probably mean banks are struggling more than we currently expect, which would likely come with downgrades.

Early Results Show A Rebound In Bank Earnings And Lower Forbearance, But Pressure From Low Rates

The banks that have reported third-quarter results so far have generally reported sharp declines in provisions for credit losses, leading to a rebound in earnings from the prior two quarters. They generally made little change to their allowances for credit losses after substantially building those allowances in the first half of the year.

Banks found room to lower provisions after the proportion of loans on deferral or forbearance fell meaningfully. For instance, JPMorgan Chase & Co. (JPM), Bank of America Corp. (BAC), and Wells Fargo & Co., the country's three largest banks, reported drops in consumer loans on deferral of 53%, 76%, and 37%, respectively, in the third quarter. JPM and Wells said 3% and 5% of their consumer loans, respectively, were still on deferral.

However, criticized commercial loans have risen for some banks. We believe certain types of commercial loans will struggle to perform even if the government extends more stimulus to the economy. Industries directly affected by the pandemic, such as retail, hotels, and entertainment, may have permanent damage. Certain types of commercial real estate such as retail, lodging, and office will also face pressure over an extended period.

Banks active in capital markets also benefited from substantial year-over-year improvement in investment banking and sales and trading. Their results fell from some of the record or near-record results from the second quarter, but generally remained strong. Banks reported strength in both fixed income and equity trading across products on high volumes and wide bid-ask offer spreads. Debt and equity underwriting revenues were also strong as companies took advantage of good market conditions. The outsize liquidity support the Federal Reserve provided to markets has supported asset prices and helped credit spreads narrow.

However, ultralow interest rates have eaten into banks' net interest income and led to the lowest net interest margins in decades. If capital market revenues decline or provisions increase again, the impact of this weakness on earnings will become more apparent. The net interest income of JPM, BAC, and Wells each fell by a mid-single-digit percentage from the prior quarter and was down by 9% (JPM), 17% (BAC), and 19% (Wells) from the prior year.

Banks, Still Facing Potential Material Asset Quality Stress, Have Maintained Good Capital And Liquidity

In August, we set our base-case forecast for pandemic-related loan losses for Federal Deposit Insurance Corp. (FDIC)-insured banks in aggregate at about half of the 6.3% loss rate the Fed projects for the 33 banks part of the 2020 Dodd-Frank Act Stress Test (DFAST) (see "What Lies Ahead For U.S. Bank Provisions For Loan Losses," Aug. 12, 2020).

At a 3% loss rate, banks would be far from done with pandemic-related provisions. At the end of June, the ratio of allowances to loans for rated U.S. banks rose to a median 1.7% (from 1.0% at year-end 2019) and an aggregate 2.7% (from 1.3%). Early earnings results indicate those ratios did not change materially in the third quarter. If our base case proves roughly accurate--which will depend largely on the economy and government support measures--we would expect rated banks to report positive, but muted, earnings in roughly the next four quarters, on average, because of the continued need for loan loss provisions.

As we review all third-quarter bank results, we will continue to consider this estimate, also factoring in the updated forecast from our economists and any additional stimulus the government may extend. We view a 3% loss rate as an adverse case and much less severe than the loan losses from the 2008-2009 financial crisis.

In an optimistic scenario, with more government stimulus and a continued meaningful economic recovery, we could lower that estimate for losses. However, if COVID-19 cases keep rising and the economy slows, we could maintain or even raise the loss estimates.

Positively, banks have seen significant rises in liquid assets, largely because of the Fed's quantitative easing. Their regulatory capital ratios generally have risen as the Fed has also restricted large banks from repurchasing shares through the end of the year or from raising their dividends. The Fed has also provided some regulatory relief regarding capital ratio calculations, including a delay of the impact of the newly implemented current expected credit losses (CECL) accounting standard for setting allowances. In contrast, banks' risk-adjusted capital (RAC) ratios--based on our measure--have seen more pressure without those relief measures. However, we believe capital remains in relatively good shape.

NBFI Negative Rating Actions Have Subsided After Significant Activity Earlier In The Pandemic

Year-to-date 2020, we have taken about 95 negative rating actions, of which about 75% were related to COVID-19, on asset managers, securities firms, specialty finance companies, and other NBFIs. Since August, negative actions have subsided as funding markets stabilized, asset prices increased, and asset quality showed less stress.

However, we still think NBFIs with high exposure to energy, commercial real estate, hospitality, residential mortgages, and leveraged loans, as well as asset managers with substantial amounts of asset-based fees, are some of the companies most at risk to the COVID-19-related downturn. Exchanges and technology-driven trading firms could be more insulated because of surging trading volumes.

Commercial real estate finance companies

Although financing conditions have improved from earlier this year, we have negative outlooks on commercial real estate finance companies and see challenges ahead. Many of these companies hold construction and transitional loans, and uncertainty remains for many property types, in our view. While hotels and retail have been directly affected by COVID-19-related closures, we see uncertainty regarding the long-term demand for office space. Many of these companies rely heavily on repurchase facilities for funding, and in some cases for more than half of their borrowing, which poses liquidity risks if financing conditions deteriorate.

Business development companies

We see more downside risk than upside potential for business development companies (BDCs) in the second half of the year, and they could have negative outlook revisions or downgrades if asset quality significantly weakens, leverage rises, earnings fall below expectations, nonaccrual loans increase, or funding or liquidity deteriorates. Although, overall portfolio valuations generally rebounded in the second quarter from the first quarter of the year, many BDCs placed additional loans on nonaccrual status and payment-in-kind income increased.

Consumer finance companies

Although asset quality has been solid so far for many consumer finance companies, we believe risks remain in the coming quarters and will continue to monitor loan performance as government support programs and lender deferments expire. We believe consumer delinquencies and charge-offs have been lower than expected, thanks to enhanced unemployment benefits and the PPP, as well as deferrals granted by lenders.

Mortgage servicers

Earlier in the pandemic, a surge in residential mortgage borrowers choosing forbearance threatened the funding and liquidity of mortgage servicers. Servicers are required to advance principal and interest payments to residential mortgage-backed security trusts, even when mortgage holders stop making payments to them. However, forbearance ratios have fallen meaningfully from their highs in the spring, and strong refinance activity bolstered liquidity and cash earnings.

Securities firms and financial market infrastructure

The rebound in securities markets since March has helped most retail and institutional securities firms' earnings. COVID-19 and the upcoming election call into question the sustainability of the market rebound, particularly in the absence of either an economic turnaround or further government action to boost the real economy. Despite such uncertainty, we believe ratings in the sector should be more stable than some other NBFI sectors given most firm's liquidity and capital levels, as measured by our RAC ratio.

Firms with material loan books or securities inventory have mostly avoided material credit and market losses that could have eroded the RAC ratios. Most retail firms continue to suffer lower, but still largely adequate, profitability because of very low short term rates, which limits returns on clients' uninvested cash balances.

We expect the technology-driven trading firms and exchanges we rate to benefit from market volatility and surging trading volumes, offsetting any potential declines in nontrading revenues (such as from reduced listings for the exchanges). While the volatility has come down slightly since June, the outcome of the presidential election may create another wave of increased volatility, benefiting these firms. Payment infrastructure companies' gross payment volumes have suffered because of a decline in cross-border and in-store payments back in March. While they have somewhat recovered in the second and third quarters, credit and settlement risks are rising in that sector.

Asset managers

Equity markets rebounded close to 50% from mid-March until the end of third-quarter 2020, leading to a substantial recovery in asset prices. Traditional asset managers had an increase in assets under management (AUM), leading to higher management fees while benefiting from lower operating costs as the pandemic limited travel and other discretionary costs.

Many alternative asset managers viewed the surge in volatility as an opportunity to deploy capital faster, leading to higher management fees and overall better fee-related earnings. Rising asset prices also support a more benign environment for realizations as the valuation of the underlying investments benefit from the recovery in equity markets.

While the increase in asset prices led to better earnings as the year progressed, we expect both traditional and alternative asset managers will exhibit, on average, lower cash flow generation in 2020 relative to 2019 as average AUM levels are lower and realizations remain limited. Additionally, the potential for increased volatility following the upcoming presidential election and impact from rising COVID-19 cases in the domestic economy could add a layer of pressure to asset managers' earnings in 2020.

Prior to the COVID-19 outbreak, we already had negative outlooks on several traditional asset managers. The pressure from passive investment on active managers led to a substantial loss in AUM in recent years and resulted in reduced cash flow generation. In our view, the surge in volatility in 2020 is not expected to materially alter the shift from active to passive and therefore does not materially alter our negative view on the sector.

Alternative asset managers, on the other hand, continue to have a stable outlook as these companies continue to benefit from investor interest, fundraising remains strong, and their AUM is predominantly locked for multiyear periods. While we anticipate that realizations will be, on average, lower in 2020 versus 2019, we already incorporate a meaningful level of stress in future realizations as we view these revenue sources as more volatile.

NBFI funding

Regarding funding, we expect debt issuance activity and financing costs for the largely speculative-grade NBFIs we rate to be choppy and opportunistic. Issuances we have seen since mid-March have largely been to build liquidity as a defensive measure. Positively, only a small portion of this debt comes due this year.

Canadian Banks: Prepared For Home Prices, Commercial, And Other Risks

So far in 2020, Canadian banks have built credit reserves, and improved their capital ratios, while coping with compressed margins and fewer opportunities to cut costs. On average, net income at the Canadian domestic systemically important banks (DSIBs), while still positive, is expected to decline by about 30%-50% compared with 2019 levels, reflecting higher provisions, lower interest rates, and high on-balance-sheet liquidity. An economic recovery is ongoing yet incomplete, but should provide support for banks as it gathers momentum in 2021. Profitability could also reverse its decline, albeit remain lower than 2019.

Canada's government recently extended most of its generous fiscal support measures until June 2021, with some revisions. We believe these programs and the measured reopening of the economy have helped Canadian banks prepare for a potential uptick in credit risks emanating from defaults once the government support ends or if unemployment remains elevated for an extended period of time. Our base-case scenario for 2020 assumes provisions for credit losses will increase to approximately 3x the 2019 levels, or 1.2% on average, before declining sharply in 2021 as credit losses materialize. We believe impairments will rise, albeit from low levels, and will peak in 2021 at about 70 basis points (bps).

Our sensitivity analysis (under our stylized credit stress test) indicates that DSIBs' capital and liquidity have enough strength to endure adverse downside scenarios, characterized by credit losses of up to 1.8% (5x the average 2019 loss rate). We expect the DSIBs' RAC ratios will remain within our adequate range of 7%-10%, even under our stylized adverse stress scenario.

Currently, approximately 9% of Canadian DSIBs' total loans are under payment deferral, with mortgages accounting for the bulk of deferred loans. But, we believe Canadian residential mortgage exposures are structurally sound because about 36% are backed by mortgage insurance, and the average loan-to-value ratio on the uninsured mortgage portfolio is quite low, at about 55%, which offers ample buffer. Moreover, the government support programs, reduced spending, and payment deferrals have resulted in an increased household savings rate (to an unprecedented 28% in the second quarter of 2020 from 3% at year-end 2019), implying improved debt servicing in the near term once the deferral programs end.

As a result, we believe the risk of a potential "payment cliff" and peak in delinquencies has been delayed until mid-2021. We also expect a short-lived correction in housing prices that will be manageable from a credit standpoint, before continued demand-supply imbalances start pushing prices up again. Given the historically strong credit performance and strong underwriting metrics of mortgages loans, we do not expect any meaningful transition from the deferrals, some of which may have been taken opportunistically, to delinquencies or defaults within the mortgage portfolio.

We believe most losses within the commercial and business loans are likely to occur earlier than with the retail loans. DSIBs' exposure to high-risk commercial borrowers (particularly within media, entertainment, leisure, tourism, hospitality, retail, restaurants, retail and office CRE, and transportation) is, on average, under 5%-10% of their wholesale loan portfolios, while the exposure to the oil and gas sector is even lower. We expect significantly higher loan losses from these exposures, but believe expected losses will be manageable from an earnings and capital perspective.

Funding for DSIBs has been stable, benefiting from the extensive measures by the Bank of Canada to avoid disruptions in the funding markets and continued international receptivity for the Canadian banks' issuances. DSIBs deposits grew as some corporates recycled a good proportion of their credit line draws as deposits. We expect deposit growth to remain relatively strong this year, but could decelerate in 2021.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Brendan Browne, CFA, New York (1) 212-438-7399;
Secondary Contacts:Devi Aurora, New York (1) 212-438-3055;
Sebnem Caglayan, CFA, New York (1) 212-438-4054;
Shameer M Bandeally, Toronto (1) 416-507-3230;
Matthew T Carroll, CFA, New York (1) 212-438-3112;
Brian Estiz, CFA, New York (1) 212-438-3735;
Robert B Hoban, New York (1) 212-438-7385;
Stephen F Lynch, CFA, New York (1) 212-438-1494;
Stuart Plesser, New York (1) 212-438-6870;

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