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U.S. Financial Industry Outlook for 2012

U.S. Financial Industry Outlook for 2012

The year of 2011 seemed to be a nightmare for much of the financial industry.  In August, as the swelling U.S. debt burden caused political tension between the two parties, S&P promptly downgraded the U.S. long-term debt rating from the attractive AAA to AA+. Then, fear of the European debt situation spiraled out of control.  As a result, rating downgrades of global banking institutions and European nations occurred. The spread between German 10-year yields and credit default swaps, which represent the annualized cost for protection against issuer default, for sovereign debt issued by the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) drastically increased for each of the countries with the exception of Ireland, reflecting the uncertain economic conditions in Europe. Banks in the United States also felt a significant impact from the economic uncertainty in Europe, as they are linked to the Eurozone countries and banks within them. Overall, major U.S. banks like Bank of America, Goldman Sachs, Morgan Stanley, JP Morgan, etc. experienced declines ranging from 20% to nearly 60% in their stock prices for 2011 as a whole.[i]

Although a recurrence of the daunting 2008 meltdown is unlikely in 2012, the potency of the banking industry is not expected to return to its pre-recession glory days any time soon. As Liz Rappaport and Dan Fitzpatrick of the Wall Street Journal said, there is a “grim new reality for U.S. Banks: slow economic growth that tamps down loan demand, low interest rates that pressure investment returns, volatile markets that inhibit risk-taking and tighter regulation that adds to bulging costs—not to mention a rising wave of populist, anti-bank sentiment.”[ii] The sector faces significant headwinds in the near-to mid-term in this new reality. The major themes that will govern the banking industry in 2012 will be the European debt crisis, real estate loan issues, attempts to grow revenue and shrink costs, adjustments to adherence of new regulations, and rising political and social influence on the industry.

The European Sovereign Debt Crisis

The economic conditions in Europe will likely still have a major impact on banks in the United States throughout 2012. With no clear resolution to the crisis in Europe in sight, the problems in the Eurozone are expected to have a prolonged and uncertain outcome.  Thus, U.S. banks will be looking to take several steps to limit their exposure to potential lingering problems in Europe.

First, banks will conduct more frequent stress tests to assess capital levels. On November 23, 2011, the Federal Reserve announced that the 31 largest US banks would be measured against a deep-recession scenario. The scenario entails an unemployment rate of 13% (the current unemployment rate is 8.5%[iii]), an 8% drop in GDP growth, and a 52% collapse in stock markets between third quarter 2011 and year-end 2012[iv]. This test is an attempt by the Fed to bolster confidence and reduce systemic risk in the U.S. financial system.

Banks will also likely make efficient use and allocation of their capital a top priority.  Banks have been trying to address asset-quality troubles, highlighted by their nonperforming assets. Regulatory requirements have forced banks to sell non-core assets in order to maintain required capital ratios, and hold sufficient cash to fortify their balance sheets and act as a buffer in case a Greek default occurs.

Analysis by Goldman Sachs focused on counterparty risk, or the exposure of U.S. financial institutions to European lenders. According to Goldman, European banks currently hold about $1.8 trillion in claims on U.S. counterparties, or 3.3% of total U.S. debt outstanding. If a crisis caused European banks to cut lending to U.S. residents by 25%, which is roughly equal to the peak pace in the 2008-2009 financial crisis, U.S. growth could be cut by .4%, making our recovery highly susceptible to shocks.

There could potentially be an upside from the weakness in Europe to the larger U.S. banks. Through government-assisted acquisitions of European financial institutions, large banks that are above the 10% domestic deposit cap as defined by the 1994 Riegle-Neal Interstate Banking and Branching Efficienct Act may seek the opportunity for expansion.

Real Estate Loan Issues

Many banks are happy to bid adieu to 2011 as the year penalized banks for questionable lending practices and securities fraud. However, punishments for the banks’ role in the financial crisis will likely continue throughout 2012. Impending lawsuits that have potential for hefty fines could reduce banks’ value and ability to lend[v].

In order for banks to alleviate the housing crisis for which they were partly responsible, a significant improvement in the housing market is necessary. Mortgage interest is vital to the survival of many banks, and they will see huge losses in revenue if they are not approving and writing new mortgages.  Foreclosures are not the answer to this problem.  Unfortunately, a new wave of foreclosures appears to be on the horizon for 2012, if the recent spike in default filings is any indication. Also, the significant amount of investigations has caused mortgage servicers to re-evaluate their procedures, which has caused a slowdown in processing. “The foreclosure processing delays mean much of the foreclosure activity that under normal circumstances would have occurred in 2011 is being deferred to 2012,” said Daren Blomquist, RealtyTrac’s director of marketing communications[vi]. Banks do not make money on empty, neglected homes, which steadily fall in value, and also cause the value of homes around them to decline^v.

In order to reverse the housing crisis, banks must help to save homes from foreclosure and declining property values by modifying existing mortgages. This should also help to prevent future litigations and in the long run, benefit homeowners, lenders, and the economy. One-quarter of all mortgages are currently underwater (meaning that the balance owed on the mortgage exceeds the value of the real estate). Homeowners will not be willing to pay banks and we will continue to see foreclosures until the value of homes and mortgage balances meet^v.

Attempts to Grow Profits and Shrink Costs

Although increasing profits and containing costs is always on corporate agendas, it will likely be the central focus for banks in 2012. This will be quite the challenge.

With interest rates extremely low across the board, commercial banks’ interest margin will have little room to improve. Additionally, although some analysts predict minor loan growth, “It appears that much of the commercial loan growth we have seen at the large cap banks is coming from large corporate syndicated lending. Not all banks are players in this market,” said Christopher Mutascio at Stifel, Nicolaus & Co. He is also expecting “total loan growth and commercial loan growth” to slow in 2012[vii]. In addition, if banks attempt to increase their interest margin by investing in assets with longer maturities, it could backfire once interest rates start rising again. Therefore, banks will likely have little opportunity to increase profits through interest income.

An option to boost revenues that banks will likely have to pursue is introducing new fees, increasing minimum balance requirements and encouraging customers to use credit cards. However, these attempts will likely be hindered by regulatory actions, and disapproval from customers, which could cause them to switch banks. Therefore, a goal for banks will be to convince their customers that the fees and requirements are necessary in order to retain their business.

Placing an emphasis on wealth-management services, especially in emerging markets, could help boost revenues. Wealth controlled by so-called “millionaire households” in the 25 largest global economies is forecasted to grow from $92 trillion in 2011 to $202 trillion in 2020[viii] .

Banks will also seek ways to cut costs. As a result, they will likely continue to cut jobs and salaries, as well as reduce operating costs by selling non-core assets, which will also provide the banks with more liquidity.

New Regulations

Following the latest recession, the regulatory environment has become tougher and costlier for U.S. banks. The majority of new regulations aim to make banks self-sufficient in the long term, although the costs from compliance will reduce profitability in the short and mid term.

Although no new major financial services legislation is anticipated in 2012 largely as a result of the presidential election, banks will continue to focus on implementing many of the fundamental provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act and The Basel III.

The Dodd-Frank Act includes the Volcker Rule, which places trading restrictions on financial institutions, including separating the investment banking, private equity and proprietary trading sections from their consumer lending arms. The rule aims to mitigate conflicts of interest between banks and their clients[ix]. The effective date is July 21, so financial institutions are assessing the potential impact of the rule. It is estimated that the Volcker Rule will cost the industry more than $1 billion for compliance, infrastructure, and capital[x].

The Dodd-Frank Act also requires banks to produce “living wills,” which are blueprints with full descriptions of ownership structure, assets, liabilities, and contractual obligations. Federal regulators can use the documents to comprise recovery and resolution guidance plans for banks[xi].

There have also been new agencies created for regulatory measures on financial institutions, including the Consumer Financial Protection Bureau (CFPB), and the Office of Financial Research (OFR). The CFPB will take the lead of many consumer issues, focusing on many of the disclosures that banks and securities firms use daily. The OFR has been given the responsibility of collecting and analyzing substantial amounts of data from the banking and securities industry. Additionally, the Basel III measures require banks to maintain proper leverage ratios and meet certain capital requirements[xii].

The significant changes and additions to regulations on banks will require considerable adjustments to business plans, incurring large costs on banks in order to meet these requirements. Although these costs will hurt short term profits, they aim to build long term stability in the financial sector.

Political and Social Influence

The failure of the Joint Select Committee on Deficit Reduction to identify ways to reduce the U.S. debt did little to remove uncertainty from the marketplace in 2011. As political focus will shift to the presidential election, and likely address the issue of job creation, it is unlikely that federal leaders will address problems with the housing market until after the elections. Banking and securities executives will likely continue to encourage their Congressional representatives to work more cooperatively with members of the opposing party for the benefit of the financial services industry as well as the entire country.

Social activism is also likely to have a major impact on banks in 2012. Consumers can now employ social media channels to organize and promote points of view against both government and big businesses.

Banks will face the challenge of responding to customers’ protests to fees in order to prevent them from moving their account to another financial services provider. The banking and securities industry will need to help people understand why certain fees are necessary and why loans must be repaid, while also endeavoring to comprehend the customers’ concerns.

Investing in the Financial Sector in 2012

Five of the largest U.S. banks (JPMorgan, Bank of America, Citigroup, Goldman Sachs, and Wells Fargo) have started off the New Year very strong, with an average return of 41.89% thus far[xiii]. Investors likely saw the relatively cheap prices for banks’ stocks, which had been beaten down from the constant negative headlines out of the Euro Zone in 2011, as a perfect opportunity to invest in these stocks. If the trend continues, the outlook for the U.S. economy remains positive, and there is an easing of the Euro Zone debt crisis, bank stocks could return to normal levels over the next couple of years. According to analyst Gerard Cassidy of RBC Capital Markets, “though the stocks have had a strong move since October 3^rd, their valuations are still very compelling relative to book value and tangible book value.”[xiv]

Nevertheless, the industry is still on shaky ground. Increasing loan losses on commercial real estate could trigger bank failures in the upcoming years, but the number of failures in 2012 is not expected to exceed the 2011 tally[xv]. Strong banks may continue to take advantage of strategic opportunities to gain competitive advantages, weeding out smaller banks that do not offer as many products or services as the larger banks. An alternative to some of these smaller banks failing is that larger banks could see opportunities to buy them. Among small and mid-cap banks with strong local market presence, several could be potential acquisition targets. Analysts believe that some banks that fit this category include Associated Banc-Corp, Investors Bancorp Inc., Cape Bancorp and United Financial^xiii.

Conclusion

The banking industry’s outlook for 2012 can be summed up by one word: evolution. Banks need to adapt to the macroeconomic conditions and find ways to maintain profitability, while also adjusting operations to meet new regulations and acknowledge customer desires.

Although the beginning of 2012 has been strong for the banking industry, and the outlook for the U.S. economy still remains positive, if the European debt crisis worsens and contagion spreads issues to the U.S., banks will certainly take some heat. However, if the macroeconomic conditions remain unproblematic, then investing in U.S. banks’ beaten down stock prices could result in significant returns as their share prices return to normal levels.

Securities offered through Securities America Inc., Member FINRA/SIPC and advisory services offered through Securities America Advisors, Inc. Armstrong Advisory Group and the Securities America companies are unaffiliated. Representatives of Securities America, Inc. do not provide legal or tax advice. Please consult with a local attorney or tax advisor who is familiar with the particular laws of your state. 3/12

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