October ’19

The BAN Report: Regional Bank Earnings Review / Banks Boost P/E Lending / The Trillion-Dollar Hit / Hourly Fees for RE Brokers?-10/31/19

Regional Bank Earnings Review

For the third quarter, we decided to review the earnings from a few of the super-regional banks.    We looked at Capital One, KeyCorp, Regions, and East West Bank.   We chose these randomly, but tried to provide some geographic diversity.

Capital One

Capital One Financial had a series of non-recurring charges that led to a 11% decline in net income.

The expenses, which totaled $318 million on a pretax basis, were connected to a long-running sales scandal in the United Kingdom, the start of a new credit card partnership with Walmart and a recent, well-publicized data breach.

Capital One recorded net income of $1.33 billion, which was down from $1.50 billion in the third quarter of last year. Earnings per share fell by 10%, but the company said they would have risen by 11% if not for the unusual items.

The largest charge was a $212 million pretax reserve build for customer refunds that Capital One expects to pay in the U.K., where the company offers credit cards. The refunds are intended for British consumers who were improperly sold insurance that was designed to cover loan payments in certain circumstances where borrower could not pay. U.K. consumers had until Aug. 29 to submit complaints.

The McLean, Va.-based firm also recorded an $84 million pretax charge in connection with the Walmart credit card deal. Last year Capital One won the right to issue Walmart credit cards, and the card issuer subsequently worked out a deal to purchase older loans that Synchrony Financial had previously made to Walmart credit card users.

These types of one-time charges are pretty unusual for banks.  Capital One also had a hacking scandal that cost them $22 million.    Loan growth has been strong, but the rate cutting has been challenging for margins.

KeyCorp

KeyCorp beat earnings expectations in the third quarter, but the bank also reported a one-time large expense in the third quarter.

An alleged fraud by an Indiana-based payroll processor has cost KeyCorp $123 million in the third quarter, erasing gains in fee income from investment banking and dragging the Cleveland-based bank’s earnings down.

Key reported net income of $383 million, or 38 cents per share, down from $468 million or 45 cents per share a year ago. Without the pre-tax fraud charge — which matched the bank’s previously disclosed expectations — the bank earned 48 cents per share, beating Wall Street expectations by two cents.

Net interest income from taking deposits and making loans fell 1% to $980 million, despite higher earning assets, as the profit margin on lending narrowed. Noninterest or fee income rose 7% to $650 million, driven by record-high fees from investment banking and debt placement, as well as corporate services income and mortgage fees.

Expenses fell 3% to $939 million, as Key’s cost-cutting efforts succeeded in bringing down salary and other expenses, while an FDIC surcharge was eliminated. Not including the fraud loss, the bank wrote off $73 million in loans as uncollectible, up from $60 million a year ago.

The Elkhart, IN payroll company Interlogic Outsourcing Inc., was alleged to have caused KeyCorp to process $122MM in wire transfers for money that the company did not have.    This month, they filed bankruptcy and were purchased for $3.5 million.

Regions Financial

Regions Financial had a solid and stable quarter, meeting earnings estimates and exceeding revenue forecasts.

Adjusted total revenues (net of interest expense) came in at $1.49 billion in the reported quarter, outpacing the Zacks Consensus Estimate of $1.47 billion. The revenue figure also increased 2.5% from the year-ago quarter’s reported tally.

Non-interest income climbed 7.5% to $558 million. Higher mortgage income, service charges on deposit account, card & ATM fees, commercial credit fee income, wealth management income and other income primarily resulted in this upside. However, these positives were partly offset by lower capital markets income.

Non-interest expense dropped 5.5% year over year to $871 million, mainly due to fall in net occupancy, professional, legal and regulatory expenses, FDIC insurance assessments and other expenses. On an adjusted basis, non-interest expenses escalated 1.4% year over year to $865 million.

Regions seems to be heavily focused on reducing costs.    Earlier this year, they announced their plan to close 100 branches and open 75 new ones by 2021, looking to increase their presence in Houston, Atlanta, St. Louis, Orlando, and Tampa.    Since 2014, they have consolidated 284 branches and opened 33 new ones.   Additionally, they have been cutting headcount aggressively.

East West Bancorp

East West Bancorp had a disappointing quarter, missing earnings estimates by 3 cents and causing the stock to slump by 5%.

While higher revenues, rise in loan and deposit balances, and fall in expenses supported the results, substantial increase in credit costs more than offset it. Additionally, lower interest rates acted as a headwind.

Moreover, management provided disappointing 2019 guidance on the back of the expectation of one more interest rate cut. Thus, the company’s share tanked 5.1% as the concerns weighed on investors’ sentiments.

Annualized net charge-offs were 0.26% of average loans held for investment, up from 0.05% at the end of the prior-year quarter.

Further, as of Sep 30, 2019, non-PCI non-performing assets were $134.5 million, up 17.3%. Also, provision for credit losses were $38.3 million, up significantly from $10.5 million in the prior-year quarter.

Because credit quality has been so strong, spikes in NPAs are not difficult and often look worse on a percentage basis than they would in a normal environment.    We anticipate the slowing economy, particularly weaknesses in energy, agriculture, senior housing, and manufacturing will result in material increases in NPAs for banks.

Banks Boost P/E Lending

Bank loan growth to private equity funds has grown recently and some, like the American Banker, wonder if this is a regrettable trend.

Private-equity managers have been stockpiling massive funds to buy stakes in promising companies then offloading them at a profit for their investors, which are often major institutions, pension funds and university endowments. But more of these funds have been tapping lines of credit offered by banks to either help pay for businesses they are investing in, or to improve a key accounting metric used to show the rate at which they are returning profits to their clients.

Private-equity managers had typically used lines of credit from banks to bridge funding gaps for particular deals, but they are now more often using this financing to boost their internal rate of return, which is how these funds are graded for investors, who expect a certain profit within a certain time. By using bank financing in lieu of drawing committed capital from their investors, fund managers can shorten the timeline for doling out a cut of the profits to investors and essentially increase their IRR.

The market for this kind of lending sits on the edge of the so-called shadow banking system, so its exact size is hard to pin down.

However, data provided by the Federal Deposit Insurance Corp. shows the amount of lending from banks above $10 billion in assets to nonbanks — which include mortgage lenders and real estate investment trusts along with private-equity funds — passed $403 billion in the first quarter of 2019. That was up nearly 18% year over year and more than double the amount five years ago.

There are no official numbers breaking out loans to private-equity firms specifically, but the New York law firm Cadwalader, which handles a substantial amount of this business, estimates the global market for subscription lines of credit to private-equity firms has hit $550 billion year to date, a more than 20% increase from last year.

Whether these loans are risky or not is hard for us to say.   I asked a friend of mine who works in private equity, and he noted that while short-term bridge/warehouse/subscription loans have increased, banks have lost market share in direct acquisition financing to non-bank lenders.   He believes the types of loans banks are making today are typically very well secured.    Of the 15 companies his firm owns, 13 of the deals are financed by non-banks.   So, it sounds like banks are finding different ways to invest in private equity.

The Trillion-Dollar Hit

According to a research by both Fortune and ProPublica, the 2017 tax reform bill resulted in an approximately $1 trillion reduction in real estate values.

That massive number is the reduction in home values caused by the 2017 tax law that capped federal deductions for state and local real estate and income taxes at $10,000 a year and also eliminated some mortgage interest deductions. The impact varies widely across different areas. Counties with high home prices and high real estate taxes and where homeowners have big mortgages are suffering the biggest hit, as you’d expect, given the larger value of the lost tax deductions. But as we’ll see, homeowners all over the country are feeling the effects.

While Zandi and I were having the first of several phone conversations, he sent me a county-by-county list of the estimated home-price damage done to about 3,000 counties throughout the country. I was fascinated—and appalled—to see that the biggest estimated value loss in percentage terms, 11.3%, was in Essex County, New Jersey, the New York City suburb where I live.

In case you’re interested—or just snoopy—the four other counties that make up the five biggest-losers list are: Westchester County, New York, suburban New York City, 11.1%; Union County, New Jersey, which is adjacent to Essex County, 11.0%; New York County, the New York City borough of Manhattan, 10.4%; and Lake County, Illinois, suburban Chicago, 9.9%.

The study points out though that the $1 trillion reduction is not an actual loss of value, but the projected difference in value between real estate values with and without the tax law changes.   It also fails to consider how the tax law may have increased prices in lower tax states or consider the other benefits of the 2017 measure.   A small business owner may lose their SALT deductions, but they benefit from lower rates on business income.   Nevertheless, the 2017 law has negatively impacted real estate values in high tax, high property value areas.

Hourly Fees for Real Estate Brokers?

A New York times writer examined the persistent high commissions for residential real estate brokers, arguing that the entire current system is broken and efficient.

The study is “Can Free Entry Be Inefficient? Fixed Commissions and Social Waste in the Real Estate Industry,” by the economists Chang-Tai Hsieh, a professor at the University of Chicago, and Enrico Moretti, a professor at the University of California, Berkeley. They pointed out that the total in commissions paid for selling a home — as much as 6 percent, when agents for both sellers and buyers are taken into account — appears to be stuck at a high rate.

When I teach Economics 101, I tell my students that in a well-functioning market, high prices — like the commissions paid to most agents — rarely persist for long, because competitors will offer discounts to attract more customers.

But for the most part, that doesn’t appear to have happened for real estate agents. That’s because the house seller typically sets and pays the commission that goes to the buyer’s agent. This arrangement appears to have neutered competition over commission rates.

But the high commissions haven’t made most real estate agents rich: The median agent earned $48,690 in 2018, according to the Bureau of Labor Statistics.

Instead, the commissions have created a bloated and unproductive sector. That’s because the possibility of earning enormous commissions is so powerful an incentive that it has led thousands of people to become real estate agents.

When lots of agents chase a limited number of deals, many of them end up underemployed, working on only a handful of deals annually.

For example, the 2,773 New York City real estate agents employed by Douglas Elliman Real Estate closed 5,979 transactions last year, an average of only two deals per agent. (These numbers come from the annual report of Vector Group, Douglas Elliman’s parent company.)

The author was successful in finding a broker to work on an hourly basis for $120, and then rebated the commission minus the hourly fees back to the author.     But, most brokers he spoke with refused to work on this basis.    While we think his idea has merit, it would not work as you’re effectively asking someone to work for less money.    The good brokers are not going to work on an hourly basis.   Moreover, how would an hourly rate reduce the agent supply problem?

The BAN Report: Weak ISM Data Stokes Recession Fears / Hipsturbia / Manhattan Apartment Sales Tumble / Appraisal Relief Finalized-10/3/19

Weak ISM Data Stokes Recession Fears

The Institute for Supply Management (“ISM”) released its reports this week on both the manufacturing and non-manufacturing sector, indicating slowdowns in the US economy.    For the second consecutive month, the manufacturing index showed contraction and reached its lowest level at 47.8% since June 2009.    Any reading under 50% means growth is contracting.

“Comments from the panel reflect a continuing decrease in business confidence. September was the second consecutive month of PMI® contraction, at a faster rate compared to August.  Demand contracted, with the New Orders Index contracting at August levels, the Customers’ Inventories Index moving toward ‘about right’ territory and the Backlog of Orders Index contracting for the fifth straight month (and at a faster rate). The New Export Orders Index continued to contract strongly, a negative impact on the New Orders Index. Consumption (measured by the Production and Employment indexes) contracted at faster rates, again primarily driven by a lack of demand, contributing negative numbers (a combined 3.3-percentage point decrease) to the PMI® calculation. Inputs — expressed as supplier deliveries, inventories and imports — were again lower in September, due to inventory tightening for the fourth straight month. This resulted in a combined 3.3-percentage point decline in the Supplier Deliveries and Inventories indexes. Imports contraction slowed. Overall, inputs indicate (1) supply chains are meeting demand and (2) companies are continuing to closely match inventories to new orders. Prices decreased for the fourth consecutive month, but at a slower rate.

“Global trade remains the most significant issue, as demonstrated by the contraction in new export orders that began in July 2019. Overall, sentiment this month remains cautious regarding near-term growth,” says Fiore.

Today, the non-manufacturing sector report came out at 52.6, lower than the consensus expectations of 55.3.     The non-manufacturing is still expanding, but the trend is negative.    This was the weakest reading since August 2016.

According to the NMI®, 13 non-manufacturing industries reported growth. The non-manufacturing sector pulled back after reflecting strong growth in August. The respondents are mostly concerned about tariffs, labor resources and the direction of the economy.”

The 13 non-manufacturing industries reporting growth in September — listed in order — are: Utilities; Retail Trade; Construction; Mining; Agriculture, Forestry, Fishing & Hunting; Accommodation & Food Services; Public Administration; Management of Companies & Support Services; Finance & Insurance; Transportation & Warehousing; Information; Health Care & Social Assistance; and Professional, Scientific & Technical Services. The four industries reporting a decrease are: Educational Services; Other Services; Real Estate, Rental & Leasing; and Wholesale Trade.

In 2018, US GDP was 69% personal consumption, 18% business investment, 17% government spending, and negative 5% net exports.    While weakening business investment often reduces consumer spending, the strength of the US consumer will determine where this economy goes.   If the US consumer holds up, its hard to say the US slipping into a recession, but if consumer spending contracts, a recession is inevitable.

This weak business data raises the stakes for the US / China trade negotiations next week.    Growth in China is slowing and Chinese consumers are saving more and spending less.   Conditions should appear ripe for a trade deal, but both sides have been unpredictable.    Continued speculation on the ups and downs of the US/China trade negotiations will continue to dominate global markets for the foreseeable future.

Hipsturbia

PWC and the Urban Land Institute have released their annual forecast on real estate.   Entitled “Emerging Trends in Real Estate,” this annual survey is a great barometer on attitudes on real estate.    This year’s forecast introduced a new concept – hipsturbia.

It hardly seems possible that it has been 25 years since Emerging Trends began to discuss the live/work/play environment under the rubric of the “24-hour city.” But that is a fact. Cities and their suburbs have evolved tremendously since the mid-1990s, and the “proof of concept” of live/work/play has long since been established in the sociological sense of lifestyle preferences and has also been validated in terms of superior real estate investment returns. 

Success has a way of spreading, and 24-hour downtowns have provided replicable models that many suburban communities are seeking to emulate. From dense northeastern cities like Philadelphia, to Sun Belt giants like Atlanta, to boutique markets like Charleston, our interviewees and focus groups have uncovered the desire of suburbs to create their own versions of the live/work/play district. There is a term of art being heard to capture this concept: hipsturbia. 

Many of these “cool” suburbs are associated with metro areas having vibrant downtowns, illustrating the falsity of a dichotomy that pits central cities against ring communities. One of our Jacksonville, Florida, respondents noted, “You can’t be a suburb of nowhere.” Even in an enviably active small downtown, such as Charleston, South Carolina, our focus group related, “People want to work in a mixed-use environment,” even as they seek more manageable housing costs than in the booming center of town.

Leading hipsturbias cited included Brooklyn, NY, Hoboken, NJ, Santa Clark, CA, and Evanston, IL.    With recent census data suggesting that millennials are leaving downtowns, many are projecting these types of suburbs will benefit disproportionately, as they can offer many downtown amenities at a more favorable price point.    Additionally, we have argued that downtowns are doing a poor job at providing home ownership options to millennials.

Manhattan Apartment Sales Tumble

According to the Wall Street Journal, home prices on Manhattan apartments plummeted in the third quarter to the weakest levels in 4 years.

The Manhattan co-op and condo market had been in a slump for several years as buyers resisted many sellers’ overly optimistic prices, according to Gregory J. Heym, the chief economist for brokerage firms Halstead and Brown Harris Stevens. He said that the gap between buyers and sellers was now shrinking.

“The data is terrible,” he said. “Even with the rush before the taxes and hangover afterwards, we are still in a sluggish market.”

The declines for properties selling for $2 million or more was striking, illuminating the powerful impact of tax increases even on very affluent buyers.

During the second quarter, the median price of a Manhattan apartment rose 19.3% to a record of nearly $1.4 million, after accounting for a rush of sales during the last week in June. But in the third quarter, the median price fell to just over $1 million, a decline of 25%, to the weakest pricing since 2015. The figures include sales filed with the city as of Sept. 27.

The average price of a Manhattan apartment fell to $1.7 million from just under $2.5 million in the second quarter, a decline of 32.4%.

Some of the volatility is due to increased state and local transfer taxes, which saw increases in July.    Some are calling this the worst real estate market since 2008.      According to an analysis by the New York Times last month, one in four of the new condos built since 2013 are unsold.    In addition to a potential slowing economy, it has been more difficult for foreign buyers to launder money by purchasing luxury apartments.

Appraisal Relief Finalized

It’s been a tough week, so glad to report some good news!   This week, the Banking Agencies finalized a new rule that allows banks to avoid appraisals on transactions under $400,000.    Banks can obtain evaluations instead.

The appraisal threshold was last changed in 1994. Given price appreciation in residential real estate transactions since that time, the change will provide burden relief without posing a threat to the safety and soundness of financial institutions.

For transactions exempted from the appraisal requirement, the final rule requires institutions to obtain an evaluation to provide an estimate of the market value of real estate collateral. Evaluations are generally less burdensome than appraisals and have been required since the 1990s.

The final rule incorporates the appraisal exemption for rural residential properties provided by the Economic Growth, Regulatory Relief, and Consumer Protection Act and similarly requires evaluations for these transactions. The final rule also requires institutions to review appraisals for compliance with the Uniform Standards of Professional Appraisal Practice.

The agencies have consulted with the Consumer Financial Protection Bureau (CFPB), and, as required by statute, have received its concurrence on the increased threshold. The CFPB released its letter concurring that the increased threshold provides reasonable protection for consumers who purchase 1-4 unit single-family residences.

Effectively, this means that a $399,000 loan will on a residential property will not require an appraisal.   Additionally, rural residential properties (defined in 12 CCR 1026.35) are exempt as well.   In 2010, the Agencies defined what needs to be in an evaluation.

An evaluation must be consistent with safe and sound banking practices and should support the institution’s decision to engage in the transaction. An institution should be able to demonstrate that an evaluation, whether prepared by an individual or supported by an analytical method or a technological tool, provides a reliable estimate of the collateral’s market value as of a stated effective date prior to the decision to enter into a transaction.

BPOs are excluded as acceptable alternatives.    We have only seen a few banks use internal evaluations, so it remains to be seen whether other banks will develop their own internal evaluation systems.   Banks could save their customers money and time if they adapt internal evaluations.

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