For major banks, the next few years will be a return to a simpler and possibly less-profitable time.
The subprime crisis and ensuing credit crunch have thrown a wrench into the highly profitable bank business model: Make loans that are then sold off to investors while arranging corporate financing through off-balance-sheet vehicles that keep banks’ capital costs down.
Now, banks are holding on to more of the loans they make, as they did years ago. And the off-balance-sheet lending business is crippled. It isn’t clear how long this will last, or how the banking model might evolve in response to the current market crisis. What is clear is that some of the banks’ more profitable lines of business have been shut, either temporarily or permanently.
The upshot: Bank investors expecting a big rebound in earnings growth after the debacle of 2007 will likely be disappointed. The slowdown is likely to be especially pronounced at some of the biggest banks, such as Citigroup Inc. Bank of America Corp. and J.P. Morgan Chase & Co.
Just how bad the earnings slowdown could be is tough to gauge. That is because the changes hit banks on a number of different levels: Less securitization means lower fee income; more loans on the balance sheets mean higher capital charges; bigger balance sheets mean less capacity to make new loans.
But the overall impact is expected to be negative. Through 2006, the three big banks’ average annual profits had grown at a roughly 20 percent clip during the past three years, according to data provider Capital IQ. That is likely to slow significantly, analysts say.
Through 2009, the three banks’ combined earnings are expected to be just 5.5 percent higher than they were at the end of 2006, according to some analyst forecasts.
”Banks are going to have to think real hard about what their new business model is,” said Christopher Whalen, managing director at Institutional Risk Analytics, a banking research firm. ”It was a different world when they could just set up another (off-balance-sheet vehicle) and put this stuff out there. It gave them unlimited flexibility in balance-sheet management.”
Investors also will have to contend with another unsettling phenomenon – bank profits that may swing wildly from quarter to quarter. That is because banks are using market values for more of the assets they hold on their books, meaning their prices fluctuate like those of stocks.
That will be a big adjustment both for bank executives and for investors, who are used to thinking about the long-term intrinsic value of debt, rather than how much it can fetch if sold today. That has led to repeated write-downs at big institutions such as Citigroup and UBS AG.
Banking observers aren’t uniformly downbeat. ”I’d be reluctant to say the whole securitization market is going to fade away or depress earnings for an extended period of time,” said Bill Fitzpatrick, an equity analyst at Optique Capital Management, which owns stocks such as Citigroup and Bank of America.
Plus, banks have proved remarkably resilient in recent decades in figuring out new ways to make money. There also may be a silver lining: Banks may end up in better shape if weaned from an over-reliance on securitization, said Gerard Cassidy, an RBC Capital Markets analyst.
The originate-and-sell business model ”encouraged reckless lending” that triggered the current mortgage morass, Mr. Cassidy said. Keeping loans on banks’ books will help avoid future meltdowns that could torpedo years of profits.
Meantime, changes being wrought to the banking business model are quickly becoming apparent. Citigroup has seen the amount of loans and leases it holds in inventory – and doesn’t plan to sell to investors – increase to about $697 billion at the end of September, up about 9 percent over six months, according to data from IRA.
The bank’s portfolio of loans and leases it would like to sell, but has yet to do so, more than doubled over the same six-month period to about $42 billion at the end of September.
At J.P. Morgan Chase and Bank of America, loans and leases held for inventory increased by 11 percent and 9 percent, respectively, in the six months ended Sept. 30, according to IRA.
Commercial and industrial loans at commercial banks in the U.S. have risen about 20 percent since the start of the year to about $1.43 trillion this month, according to Federal Reserve data.
That rise has come at the same time as a fall in commercial-paper issuance by off-balance-sheet conduits typically sponsored by banks. These vehicles issue short-term commercial paper to purchase debt such as corporate receivables, mortgages and auto loans, capturing the difference in rates between the two. The amount of this paper outstanding fell to $763 billion as of Dec. 19 from a peak of almost $1.2 trillion in August.
Banks have traditionally used such conduits, which are close cousins of the now-infamous structured investment vehicles, to arrange lending without having to set aside regulatory capital. With that market shrinking, banks have to hold on to more of the loans they make.
Making matters worse, a securitization hiatus deprives banks of fees they used to collect for originating loans, packaging them into securities and selling them to investors, said Michael Poulos, a managing director at financial consulting firm Oliver Wyman.
Banks are likely to make up for those lost fees by increasing the interest rates they charge on loans, Mr. Poulos added. But that will diminish companies’ ability to take on debt, which could hurt the wider economy.
”Lending is going to be tight for the next year or two,” said David Hendler, an analyst at CreditSights Inc.
The biggest U.S. banks are likely to suffer more than their smaller peers, which relied less on securitization, said David Fanger, chief credit officer for financial institutions at Moody’s Investors Service.
In fact, the lack of a securitization market could help midsize banks.
In recent years, the intense demand for asset-backed securities fueled a lending boom that let big banks offer more generous terms on loans. Today, ”it now makes it easier for these (smaller) banks to compete,” Mr. Fanger said.