A deposit drain is coming. So, merge while you can.
That’s the advice JPMorgan Chase & Co. (JPM) has for regional banks, as reported this week in Bloomberg.
The story outlines the investment bank’s prescription to smaller banks on how to survive what it sees as a crunch that’s coming in December. A crunch that’s coming thanks to the Fed’s bond-buying program.
The Bloomberg piece cited a confidential presentation obtained by Bloomberg News, and subsequently confirmed by a JPMorgan spokesman.
Here’s the thesis, pulled directly from the Bloomberg article:
JPMorgan argues that some midsize U.S. banks — those with $50 billion in assets or less — could face a funding problem in coming years as the Fed goes about shrinking its massive balance sheet, according to the 19-page report the New York-based bank has begun sharing with clients.
The Fed’s bond-buying spree from 2009 to 2014, dubbed quantitative easing, inadvertently left the industry flush with deposits. Investors took money they got selling mortgage-backed bonds and Treasury securities to the Fed and parked it in U.S. retail and commercial bank accounts.
But now that the Fed has announced it would cease its bond-buying activity as part of the "normalization" of monetary policy, that could mean this deposit drain is heading toward midsize banks.
Now, if I were running a midsize bank, I know I would heed JPMorgan’s warning.
After all, as the Bloomberg story goes on to explain, the Fed’s bond-buying created about $2.5 trillion in excess bank deposits.
JPMorgan now estimates that about 60%, or $1.5 trillion, of that money will likely come out of those regional banks in the next four to five years … particularly "if the Fed follows through with recent guidance and begins reversing quantitative easing in December."
So, how will this process work?
JPMorgan explained the situation in their presentation titled, "Core Deposits Strike Back." A clever title, I might add.
The presentation, according to Bloomberg:
… illustrates how this process will sap bank deposits using the example of a couple who pays off a mortgage that was bundled with other mortgages and sold to the Fed. Right now, when that couple takes that money out of their bank account for that payment, the Fed uses that cash to buy another mortgage bond, recycling it back into the banking system.
A "deposit is destroyed" if the "Fed does not reinvest," the presentation states.
JPMorgan estimates that a quantitative easing-related deposit-drain could result in loan growth lagging deposit growth by $200 billion to $300 billion a year.
It’s the conclusion here that should worry not only those who operate and/or work for regional banks, but also those investors who own regional bank stocks such as those in the SPDR S&P Bank ETF (KBE) and the SPDR S&P Regional Banking ETF (KRE).
Interestingly, both of these bank Exchange-Traded Funds (ETFs) are down year-to-date. (KBE -1.1%, KRE -1.9%) However, over the past 12 months, both are up substantially. (KBE +37.9%, KRE +40.6%).
Could the recent downtrend in regional bank stocks be signaling the looming deposit drain JPMorgan has warned about?
While any deposit drain might be premature, it’s definitely something to consider if you plan on owning regional bank stocks for the long haul.
It’s also something to consider if you own a regional bank that you hear might be looking to partner with another bank in the similar deposit-drain situation.
As history has shown, mergers can be good for some stocks, and bad for others.
So, choose your regionals wisely.
Tuesday saw Sally Yates, the former acting attorney general, testify on Capitol Hill about the shortest-serving national security adviser (Michael Flynn, 24 days). It also saw President Trump fire the shortest-serving FBI director post-J. Edgar Hoover (James Comey, 3.7 years).
With all this news coming out of Washington, markets started off Wednesday’s session a bit shakily. But the Nasdaq rallied to post its fifth record close in a row at 6,129.
• Energy led stocks higher, thanks to WTI crude’s 3.2% gain that came after the EIA reported a bigger-than-expected drawdown in U.S. supplies.
• Meanwhile the Dow dropped, dragged down by mixed earnings from Disney (DIS) and suspended flight tests of Boeing’s (BA) new 737 jetliner.
• Americans less-optimistic about the economy: For the week ended May 7, Gallup’s U.S. Economic Confidence Index fell to a six-month low of +3. It hit its 2017 peak at +16 in March. (Gallup)
Good luck and happy investing,
Uncommon Wisdom Daily