With Stephen Steinour, American Banker's "Banker of the Year," at the helm, there are a lot of good reasons for investors to be excited about Huntington Bancshares' (Nasdaq: HBAN ) future. But this doesn't mean they can simply tune everything out and expect that it will all work out in their favor.
At The Motley Fool, we're no fans of watching the day-to-day turmoil in the stock market, but we do know that it's important to stay on top of what's going on at the companies that we invest in. With that in mind, here are three of the biggest risks facing Huntington right now.
The biggest risk that Huntington -- or any bank, for that matter -- faces is the possibility that a large swath of borrowers decide simultaneously to default on their loans. It shouldn't be forgotten that banks are nothing more than leveraged funds, albeit highly regulated ones. The typical bank leverages its tangible book value by anywhere from 10 to 15 times. While this boosts return on equity for shareholders -- transforming an otherwise unattractive business model returning, say, 1% into a highly lucrative one offering returns of 10% or more -- it also has a similar effect on risk. Speaking very generally, only one out of 10 loans must sour to drive the typical bank into insolvency.
As with most any bank right now, there's both good and bad news for Huntington on the credit front. The bad news is that its portfolio of toxic loans remains enlarged, as approximately 1.2% of its loans were nonperforming in the second quarter, and it continues to lose an average of $38 million every three months to loan loss provisions -- both figures are roughly twice the ideal level. Alternatively, the good news is that it's quickly moving in the right direction. Its loan loss provisions are down a staggering 92% since 2009, from $2 billion on a rolling 12 month basis down to $153 billion currently, and its nonperforming loan ratio has fallen by nearly 80% and now stacks up favorably against the vast majority of its competitors.
Interest rate risk
Regardless of how well a bank is run, there is still one risk that haunts virtually every financial institution: interest rate risk. Traditional lenders like Huntington make money by borrowing funds at low short-term interest rates -- typically from depositors like you and me -- and then lending those funds out to borrowers at higher and often longer-term rates. The difference between the two is known as the interest rate spread, or, more specifically, the net interest margin, and the physical proceeds are the net interest income. Interest rate risk thus refers to the possibility that the relationship between long- and short-term interest rates contracts or, even worse, inverts entirely.
While record low short-term interest rates have spurred profitability at traditional lenders over the past few years -- particularly as regulations continue to clamp down on fee-based income such as overdraft charges and interchange fees -- the monetary landscape is beginning to change now that the Federal Reserve appears set on driving down long-term rates as well. According to a recent article in The Wall Street Journal, net interest margins fell at 79% of lenders surveyed by investment bank Keefe, Bruyette & Woods during the third quarter. The average margin at the nation's largest banks stands at 3.12%, the lowest level since the second quarter of 2009, and has been declining consistently since the third quarter of last year.
This isn't a problem that only Huntington faces. Though larger banks such as Bank of America (NYSE: BAC ) and JPMorgan Chase (NYSE: JPM ) have substantial operations outside "core banking" -- think investment banking, trading, and asset management -- they still rely in large part on interest rate spreads.
In Huntington's case, though, the seriousness of this situation cannot be denied, as net interest income accounts for nearly two-thirds, or anywhere between $400 million and $430 million, of its total revenue each quarter. At the same time, however, it's illogical to assume that the Federal Reserve would compress interest rates so far as to cause widespread disaffection within the banking industry. The more likely scenario is that the resulting pain will only further consolidate the gains of stronger banks like Huntington over the past few years.
The final type of risk confronting lenders like Huntington relates to the litany of new laws and regulations that have been, and continue to be, passed in the wake of the financial crisis -- each of which threatens to further erode the profitability of banks.
In July 2010, the Federal Reserve Board amended Regulation E to prohibit the charging of overdraft fees for debit card transactions unless the customer opts in to overdraft service. A year and a half later, the so-called Durbin Amendment, a last-minute addition to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, went into effect and limited the interchange fees banks charge on debit card transactions, decreasing Huntington's debit card income by $21.5 million in the first half of 2012.
More recently, this past January, regulatory guidance affecting the treatment of junior-lien loans resulted in an increase in Huntington's nonaccrual assets by $8.7 million in the first quarter of 2012. And in the third quarter of this year, new regulatory guidance was issued requiring loans discharged under Chapter 7 bankruptcy and not reaffirmed by the borrower to be charged off to their collateral value and considered nonaccrual, regardless of their delinquency status.
Finally, heightened capital requirements, known as Basel III, will start phasing in over the next few years, necessarily driving down returns in the financial space for the banks that are not already positioned to meet the new standards. Notably, this doesn't seem to be the case with Huntington. In its most recent quarterly report filed with the SEC, it noted, "We anticipate that our capital ratios, on a BASEL III basis, would continue to exceed the well-capitalized minimum requirements." And in its 2012 third-quarter earnings release, the bank reported a Tier 1 common risk-based capital ratio of 10.28%, up 20 basis points from the second quarter, when this statement was made.
The preceding has been a preview of the Fool's new premium research report on Huntington. To read more about whether Huntington Bancshares is a buy today -- including a look at the biggest opportunity for Huntington investors -- I invite you to download a copy of that report. Click here now for instant access.