Businesses shutting down. Schools, churches, and theaters closing. Public gathering largely forbidden. Citizens instructed to wear masks and avoid shaking hands. Hundreds of thousands of Americans succumbing to the virus. Even the President of the United Stated contracting this lethal variant of the common flu. 2020? No. Approximately 100 years ago, the 1918 Flu Pandemic (often dubbed the “Spanish Flu” as Spain, a neutral country during World War I, was virtually the only nation whose media was reporting on the rampant spread of the disease while others, including the United States, restricted news coverage in an effort to maintain military morale amidst the ravages of the conflict in Europe), would ultimately infect nearly 1/3 of the global population, claim an estimated 20-50 million lives world-wide, and see approximately 675,000 U.S. citizens die during this public health crisis. What started with the first reported case here in the U.S. at a military base in Kansas in March 1918, largely came to an end in the summer of 1919 after devastating populations and economies around the world.

Fast forward more than 100 years to early 2020, and many of the descriptors associated with the rampage of the Spanish Flu can easily be ascribed to the impact of Covid-19. Millions infected worldwide. Nearly 500,000 Americans have died, and, again, even the President tested positive (reportedly, President Wilson contracted the virus while negotiating the Treaty of Versailles in 1919 that would end WWI; President Trump confirmed a positive test and subsequent brief hospitalization while campaigning for re-election). The country’s response, as medical professionals and policymakers have dealt with a myriad of unknowns, was somewhat comparable to what the nation wrestled with a century ago (absent the significant medical advances and CDC-oriented research that has evolved over the decades). The economic wreckage, to say nothing of the loss of life, was contextually similar. Ironically, the 1920 Presidential campaign slogan for then-candidate Warren G. Harding, as the nation dealt with the devastation, costs, and fatigue of both WWI and the Flu Pandemic, was “Return to Normalcy.” With the attendant devastation of Covid-19, political pundits often referenced this same theme during the 2020 election for a nation longing to return to anything resembling pre-pandemic life in the United States. And now, exactly like in 1920, the party occupying the Oval Office also controls both chambers of Congress. Consequently, fiscal policy pursuits and their resultant economic impact remain to be seen.

This is not intended to be a healthcare treatise on Covid-19. In recent months, we’ve talked about the national response to the virus and the Fed’s consistent belief that the economic recovery will largely coincide with the course of the pandemic. Instead, this piece is intended to be an effort to help frame the current environment, and its continuing (albeit abating) uncertainties. Congress recently approved a nearly $900 billion stimulus deal and is currently negotiating additional support that could range from approximately $600 billion to nearly $2 trillion. We’ll save the discussion on the longer-term impact of a mushrooming national debt and a more than $7 trillion Fed balance sheet for another time. For now, with support from the Fed, encouragement from the Treasury, and recognition in Congress that additional aid is needed to help bridge the tenuous financial straits of those businesses and individuals that have been most directly affected by the pandemic and its resultant shutdowns, it appears that it is primarily a debate on both sides of the aisle as to the breadth and depth of how much additional stimulus is truly needed as the economy continues to slowly re-open.

On the banking front, broad industry statistics for 2020 help paint a picture reflecting the same themes of resiliency and uncertainty witnessed in both consumer households and the business community. As reflected in the chart below, banks of all sizes generally experienced total asset and deposit growth of 15% – 20% during 2020, fueled largely by government stimulus programs that had institutions awash in liquidity (note the approximate $2 trillion of additional footings on both counts at the country’s largest banks). In contrast, loan growth across the banking sector only measured roughly 5% – 10% last year, and often was a direct result of the Treasury/SBA’s Paycheck Protection Program (PPP) and not traditional, core commercial and consumer loan activity, other than an explosion in mortgage originations tied to the near-zero interest rate environment. With pandemic-induced uncertainty looming for most of 2020, banks aggressively built reserves, with the nation’s largest institutions pro-actively adding to their provision for loan losses earlier in the year before beginning to temper this effort as some visibility on the asset quality front began to emerge toward year-end. All-in, earnings were generally flat for the more than 4,000 smaller community banks, experienced moderate gains for the 654 organizations in the $1 – $5 billion asset-size range, and on average declined more than 16% at the biggest institutions.  The noticeable decline at the larger entities was in large part due to the aforementioned cautionary maneuvers on the reserve front that witnessed more than $38 billion of additional provisions year-over-year at the country’s 249 banks with assets greater than $5 billion:

Focusing on industry-wide performance metrics, the brutal combination of continued low interest rates, excess liquidity that ballooned balance sheets with cash and low-yielding securities, and the general lack of quality redeployment opportunities into traditional core loan products, effectively contributed to the intense margin pressures that had already been building for some time. Across the board, net interest margins generally declined 30-35 basis points between 2019 and 2020. With non-interest income typically flat (other than for those able to capitalize on a robust residential mortgage market) and provisioning increasing to varying degrees depending upon size and portfolio mix, pre-tax pre-provision (PTPP) levels generally declined approximately 5% – 20% across the industry. Efforts to counterbalance these pressures by pulling the oft logical lever of operating cost controls, and further supported by ongoing technological advances, reflected roughly 15% – 20% decreases in non-interest expenses as measured against average assets for most organizations (keep in mind the aforementioned comments on balance sheets that mushroomed with funding from massive government stimulus and support initiatives). Basically, control what you can without impacting longer-term franchise value. As touched on above when discussing net income, and referenced below in industry Return on Average Asset (ROAA) measures, the general earnings performance weakened as you moved up the asset scale. While typically down year-over-year (and even when profits increased, bloated balance sheets ensured this measure would effectively fall), the industry was still able to record ROAA’s typically in the 0.90% – 1.00% range during 2020:

Candidly, most investors and industry analysts looked past traditional metrics in 2020 and instead focused on underlying fundamentals related to capital resiliency, emerging asset quality trendlines and deferral/forbearance activity, operating cost controls, the technology supporting distribution channels, and risk management efforts undertaken during these unprecedented times.

As I continue to sift through the mountain of year-end Michigan-based earnings releases, I am seeing the same general themes and trends that occurred across the country: reserve building amidst growing uncertainty that moderated a bit towards year-end as visibility seemed to improve with the passage of time; active (and commendable) participation in the PPP program in an effort to get much-needed funding to small businesses struggling across the state; liquidity exploding with government stimulus, further exacerbating existent margin pressures in this low-rate environment; outside of PPP activity, core traditional loan growth tempered by economic uncertainty; mortgage-related gains fueling fee income strength that has helped many weather this storm; and, both capital ratios and asset quality metrics underlying the strength and resiliency of most balance sheets while this pandemic-induced downturn plays out.

With cash piling up, vaccines being widely distributed, businesses continuing to cautiously re-open, additional fiscal stimulus potentially being cued-up for injection into many of the hardest-hit sectors of the economy, PPP 2.0 being tapped to further bridge the dislocation gap caused by the pandemic, pent-up demand seemingly on the verge of being unleashed (which appears to be recognized by the equity markets as most major indices continue to climb the proverbial “wall of worry” to new records), and ongoing accommodative policy at the Fed designed to support the economy while artificially suppressing rates….what might all of this portend for 2021 and beyond? Are we on the brink of another “Roaring 20’s” witnessed a century ago?

I do not have the benefit of a DeLorean parked in the garage that can instantly transport me to a future point in time with access to concrete answers. As is often the case when I assess a myriad of data points and at-times conflicting information, I try to cautiously balance the prognosis for both near-term and long-term expectations. I take note of the recently released stress test scenarios for the Fed’s Comprehensive Capital Analysis & Review (CCAR) exams, as I’ve done in the past, as they often provide insight into the particular risks and challenges that regulators may see on the horizon. It is important to keep in mind that these stress test scenarios are not forecasts, but rather hypothetical dynamics simply designed to test the resiliency and sustainability of our nation’s biggest banks (and, by extension, the financial sector at large). This year’s severely adverse scenario again stresses commercial real estate values, increases volatility in the bond market while witnessing dramatic spreads with regard to investment grade corporate debt, and pushes unemployment toward 11% for an extended period accompanied by a more modest timeline for jobs recovery. Again, hypothetical, but potentially loosely translating into the possible extreme economic pressures that could emerge if the recovery is delayed as wide-spread business shutdowns and restrictive stay-at-home orders return should control of the virus takes a decidedly negative turn. Today, national unemployment measures approximately 6.3% after peaking near 15% (and roughly 24% here in Michigan) in the early days of the pandemic. Gains are now coming somewhat grudgingly, but most importantly, they are coming. However, it is sobering to keep in mind that while unemployment measures continue to improve, today there are still nearly 10 million more people that remain idled versus a year ago.

And while the current round of CCAR tests are now just underway, the more recent volley of industry stress testing a few months ago yielded results that gave the Fed enough comfort to begin lifting dividend and stock buyback restrictions that had been imposed as Covid-19 took hold. This clearly seemed to signal that  the relative strength and resiliency of the financial sector entering this downturn was generally healthier than experienced during the Financial Crisis. And ongoing reserve building and capital preservation during 2020 seemingly only served to underscore the ability of most banks to weather the potential ultimate impact of this pandemic.

However, are significant inflationary pressures beginning to build? As the economy continues to move closer to fully re-opening, demand increases across multiple components of the economy are more firmly coming head-to-head with supply shortages (i.e. residential housing stock, automobile production, etc.). Hard data over an extended period will likely be needed before we see any meaningful shift in the Fed’s currently accommodative monetary policy. Back last April we talked about the Fed slashing interest rates close to zero and overseeing a new quantitative easing program. Those monetary policies remain intact and are now further guided by an approach to any inflationary pressure that is designed to provide the Fed with added flexibility on potential moves in the future. Efforts to support the economy, albeit in an environment that portends low rates for quite some time, continues to be warmly received, particularly by the equity markets. And, as my colleagues so eloquently and succinctly framed it in a recent company communication (The Austin Advisor; 2/15/2021), and I paraphrase here, it will probably take more than a few Quarters of elevated inflationary readings north of 2% to drive any meaningful Fed policy change after more than a decade of subdued inflationary measures well below 2%.

Yet we have seen the long-end of the yield curve elevate approximately 40+ basis points in recent months, while the shorter-end has remained relatively static, as these inflationary pressures build. And while that uptick on the long-end may sound dramatic, it is still roughly 30 basis points below where it was a year ago pre-pandemic. It will be critical to monitor the implications (and potential opportunities) of a possible further steepening of the yield curve on both the economy and the banking sector. While bank stock valuations have picked-up noticeably in the past few months (see attached Summary), most institutions still hover at-or-around tangible book value. Additional clarity on the economic horizon would appear to be mitigating downside risk, but even with all the positive “noise” around PPP efforts and robust mortgage markets contributing to operating revenues and helping somewhat offset both margin pressures and reserve building, the magnitude of future credit losses still remains an open item. The positive: that picture does not look as dire as it did just a few Quarters ago.

And with larger, more liquid bank stocks beginning to reflect growing premiums in their currencies, expectations for a renewal in the industry’s  decades-long consolidation trend appears to be gaining momentum. In each of the three years between 2017 – 2019 on average 250+ M&A transactions occurred in the banking sector. In 2020, as executives hit the pause button amidst the pandemic-related uncertainty, only 112 deals took place (with approximately 40% of that activity occurring before Covid-19 firmly took control of the landscape in early spring). With greater visibility, and confidence in the economic recovery, the industry’s appetite for mergers will more clearly re-emerge. For while trepidation still surely exists in some corners, the exigencies driving consolidation have not disappeared. To the contrary, in some cases they have only been exacerbated and/or accelerated by the pandemic, i.e. technology.

As I have stated before, it appears obvious that no policy or set of policies can fully assist in the recovery until the public health issue is resolved in a manner that enables us to engage and conduct commerce while balancing the healthcare and business risks. In doing so, we ideally help the U.S. economy to avoid an extended downturn. As I said back in April, business lockdowns and stay-at-home orders are not a function of consumers unwilling to spend. But they effectively cement the reality that they are largely unable to spend. With cautious optimism, and an apparent non-verbal confirmation in the equity markets, the ability and timing of moving past this pandemic appears to harbor the potential unleashing of the economy’s animal spirits.

In closing, attached please find our monthly summary of Michigan’s financial institutions. As you and your Board take your organization forward, please do not hesitate to reach out to me and/or my colleagues at ProBank Austin if we can be of any assistance in helping you assess the competitive landscape.  I look forward to re-connecting with all of you as 2021 unfolds. And again, this simple but heartfelt counsel:  Be careful.  Be smart.  Stay healthy.  Take care of your family, your colleagues, your community.  Most important, be sure to take care of yourself. God bless.