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Quantifying the Impact of Economic Contraction on System-Wide NPA Formations

Equity Research: U.S. Financials


Bottom Line: 

Following an even more bearish economic outlook, we now forecast system-wide credit deterioration on par with that post-9/11. We revise our core EPS estimates accordingly, across our coverage universe of credit- and rate-sensitive large-cap banks and specialty lenders. Note that our forecast for credit deterioration is nowhere close to that observed during the GFC, and system-wide solvency is 130% higher than it was then. Consensus expectations for a v-shaped economic recovery imply eventual investment opportunities for FIG investors, presumably after (not before) we reach peak panic.

Key Points 

Now expecting -10% U.S. GDP growth in 2Q20E. As at last Friday (3/20/20), we anticipate the spread of coronavirus (COVID-19 virus) to hit U.S. GDP by more than 12% in 2Q20E. Details regarding our more bearish than prior economic estimates are available here.

Accordingly, we now forecast system-wide credit deterioration on par with that post-9/11. Six economic factors determine the formation rate of system-wide nonperforming assets (NPAs), which, in turn, is the best leading indicator of credit-inspired bank solvency concerns. Our new forecasts for these six credit-drivers — unemployment, GDP, consumer spending, car sales, housing starts, and mortgage purchase originations — imply fundamental system-wide credit deterioration roughly on par with that observed following the terrorist attacks of 9/11/01. See Exhibit 2 for details.

Anticipated credit deterioration still nowhere near GFC levels. We do not anticipate a system-wide credit shock anything close to that observed during the great financial crisis (GFC; 2008-2009). We forecast NPA formation rates to jump +2.3% sequentially in 2Q20E versus +11.8% during the GFC. We also note that at 8% TCE/TA, the solvency of the U.S. banking system is 130% higher than it was then.

V-shaped recovery? Street forecasts are consistent in only one regard: the economic effects of the COVID-19 virus should prove relatively short-lived. Market anticipation of such a v-shaped economic recovery implies eventual investment opportunities for FIG investors, presumably after we have reached peak panic. We encourage PMs to assemble a target list now, in anticipation of decelerating growth (second derivative) in virus transmission rates, estimated as soon as early May by some epidemiologists. When the time comes (not yet), we will highlight MS (-42% YTD), C (-52%), and COF (-56%).

Meanwhile, we take another hack at estimates. We adjust downward our core EPS estimates by as much as -19% across our coverage universe of credit- and rate-sensitive large-cap banks and specialty lenders, due in part to lower than previously modeled NIMs (lower interest rates), slower expected asset growth (economic contraction), higher provisions (rising unemployment), and higher share counts (buyback curtailment). See Exhibit 5 for a summary of model changes.

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James Fotheringham US Financial Services Analyst

James joined BMO Capital Markets Equity Research as a senior analyst in 2014 and covers large-cap banks, asset managers, specialty finance, and financial technolo...

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