Banks set aside billions of dollars in expectation of massive losses as consumers default on loans

While quarterly earnings might look like those reported at the nadir of the financial crisis, the reason today — a global public health crisis — is quite different.
Image: Citibank, pedestrian
Reforms made after the financial system’s near-implosion in 2008 are credited with preventing what could have been an even bigger collapse in bank earnings this time around.Andrew Harrer / Bloomberg via Getty Images file

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By Martha C. White

Rock-bottom interest rates and preparations for a spike in loan defaults are hitting big banks. From JPMorgan Chase, the nation's largest bank in terms of assets, to Goldman Sachs and Citigroup, the country's biggest lenders are stockpiling billions of dollars to hedge against bad debt.

With COVID-19 wreaking havoc on the economy and millions of workers losing their jobs, banks expect many to stop paying their credit cards, mortgages and other loans. Since consumer spending is the lifeblood of the American economy, countless companies are expected to shutter as consumers cut back on spending, and lockdowns restrict their ability to operate normally. Business bankruptcies will have a ripple effect on the bottom lines of landlords, suppliers and their employees — potentially triggering an expansion of the amount of debt banks have to write off as uncollectible.

“These are sobering times for individuals, small businesses, mid-sized companies and corporations, and as a result, these are sobering times for banks,” said Mike Mayo, Wells Fargo Securities senior industry analyst.

While perhaps inevitable, comparisons to 2008 don’t take into account one critical difference. Before the Great Recession, lenders binged on mortgage debt (as well as derivatives and more complex bundled loans) churned out under lax underwriting standards. Banks didn’t hold on to much extra money because, the thinking went, the underlying debts were at little risk of not being repaid. When that assumption turned out to be wildly optimistic, the fallout threatened to capsize the entire financial system.

Now, lenders are bracing for widespread defaults from businesses and consumers in the coming months by setting aside billions of dollars — money that can't be invested or distributed as dividends to shareholders.

“The banks are much better capitalized today than they were at the financial crisis, yet the severity of the downturn in 2020 leads to a more rapid increase in loan losses,” said Ken Leon, director of equity research at research firm CFRA.

While quarterly earnings might look like those banks reported at the nadir of the financial crisis, the reason today — a global public health crisis — is quite different.

The current rise in COVID-19 cases and prospect of reimposed lockdowns means that even businesses that have survived thus far might ultimately become casualties.

“This is not, at its crux, a financial crisis,” said Ryan Giannotto, director of research at GraniteShares. “It just happened to be so large now that the results have cascaded onto the financial industry. But by and large, the banks have been well positioned prior to this.”

This is largely due to the lessons learned during the financial crisis. Reforms made to the banking system after the financial system’s near-implosion and subsequent bank bailouts are credited now with preventing what could have been an even bigger collapse in bank earnings.

“Their foundation, their balance sheets, their wherewithal is much stronger than before, due to the favorable regulatory intervention of the last decade,” Mayo said.

“The regulatory environment we’ve been in for the past 10 years has caused banks to have significantly better financials overall from a balance sheet perspective,” said Jeremy Bryan, portfolio manager at Gradient Investments.

The big question is what happens next.

“What are they saying about the next few quarters?” Bryan said. “What do things look like going forward? It’s more the sentiment about how things are looking for the rest of the year.”

“The government is going to play the key role in this area, and that's very hard to predict, especially during a political season,” said Giannotto. “A second stimulus round is very likely,” he said, especially if COVID-19 forces more drastic retrenchments of commercial and consumer activity.

The current rise in COVID-19 cases and prospect of reimposed lockdowns means that even businesses that have survived thus far might ultimately become casualties. Already, the pandemic has prompted big retail brand names like Brooks Brothers, J. Crew, Neiman Marcus, and JCPenney to file for bankruptcy, and the pain is expected to spread to other sectors. Meanwhile, the rate of joblessness remains higher than it was even at its Great Recession peak.

“If we see a re-acceleration of the shutdowns, that’s obviously not going to be good for banks,” Bryan said.

“The government’s done a great job of stepping in with unemployment insurance and other safety net measures,” Mayo said. “The government safety net programs make a difference for the individuals involved and helps banks extend the bridge between the pre- and post-COVID economies more easily,” he said.

Maintaining that support over the coming months will be critical — not just for banks, but for ordinary Americans.

“It’s going to be more challenging before it gets better,” Leon said.