The coronavirus pandemic has made the already confusing stock market even more difficult to understand. Not only are many stocks way more volatile right now, but the Federal Reserve and other government agencies are taking actions to intervene at unprecedented levels, skewing the entire market more significantly than perhaps any other time in history.
There is obviously a lot of information coming from different sources, but if you want to understand more broadly what is really happening with the stock market and the overall economy, the performance of bank stocks can offer real clues, especially as most large banks prepare to release second-quarter earnings reports next week. Here's why:
Banks provide broad representation
Banks are the backbone of the financial system because they supply capital to almost every segment of the economy. Average citizens go to banks for home and auto loans, builders rely on them for construction loans, and operating loans are issued to all kinds of businesses, from restaurants to retail stores to mechanics to law firms, and even giant corporations. Banks even issue loans to each other.
Because of this, they can provide a good gauge of the economy as they provide a continuing tally of which companies are paying back their debts and which industries are obtaining capital to grow. Some of these banks have hundreds of billions and even trillions in assets moving through their systems, offering a large sample size to analyze.
The loan loss provision
Even if you know very little about banks, you can still learn a lot about the broader economy by just focusing on a few different metrics on their balance sheets, which can usually be found in the investor relations section of their websites.
One metric to watch is the loan loss provision. The loan loss or credit provision is cash that banks set aside to cover potential bad loans, customer defaults, and loan renegotiations that could eventually materialize. To be clear, the loan loss provision is not an actual loss on a loan, but rather a prediction of potential losses to come. If you see the amount a bank is setting aside begin to rise significantly (particularly at a large bank), that most likely means that economic conditions are deteriorating.
A real-world example of this would be JPMorgan Chase's (NYSE:JPM) recent financial statements. This bank's assets and loan activity offer a decent representation of the overall U.S. economy, being the largest American bank by assets with more than $3.1 trillion. In every quarter in 2019, the bank's quarterly loan loss provision was between roughly $1.1 billion and $1.5 billion. But at the end of the first quarter of 2020, which included a few weeks in March when the coronavirus began to hit the economy very hard, the credit provision ballooned to $8.3 billion. That's roughly a 480% increase from the preceding quarter. Essentially, the bank is saying that $8.3 billion in loans issued now have a chance defaulting.
Banks typically break down this loan loss provision by each division in the bank too. JPMorgan said that roughly $5.7 billion of its $8.3 billion provision came from the consumer and community bank division. That strongly suggests that many of the loans JPMorgan is seeing credit deterioration on are credit card loans, home mortgages, and certain small-business business loans.
Another way to use the loan loss provision to help determine how bad things might be is to compare patterns and rates to other economic downturns. JPMorgan's loan loss provision after the first quarter of 2020, for example, was nearly as high as the bank's quarterly provision at the peak of the 2008-09 Great Recession. This is significant because the provision reached that $8.3 billion level much quicker than it did during the last recession. That suggests that coronavirus affected the economy much more suddenly than the Great Recession, and that there could be high loan loss provisions in future quarters.
Another metric worth watching on banks' balance sheets is net charge-offs. A charge-off represents a debt that is unlikely to be collected. For instance, if a business hasn't made a payment on a loan for three or four months, a bank begins to conclude it will never collect this debt.
However, a charge-off is also not a guaranteed loss as the business owner still has some potential in month four or five to suddenly pay off the loan (or return to paying off the loan). Net charge-offs are the difference between total charge-offs and debts that were charge-offs but then were recovered.
It's not always the case, but net charge-offs can be a much better representation of actual losses at a bank than the loan loss provision. The issue is that there is often a lag after the loan loss provision is reported. The provision is a sign that actual losses are coming, and charge-offs are recorded once the bank deems a loan is unlikely to be collected.
In the first quarter of the year, the loan loss provision at JPMorgan rose substantially, but net charge-offs were basically flat between the fourth quarter of 2019 and the first quarter of 2020. It's probably a safe bet you will see net charge-off levels rise once second-quarter earnings are reported next week.
Analyzing the two together
The relationship between the quarterly credit provision and net charge-offs can tell us a lot about what the banking accountants are thinking and their broader economic forecasts. Most banks project the loan loss provision conservatively (meaning they are higher than they actually expect to lose) because banks typically want to be prepared for the worst. As such, charge-offs may not actually get as high as the quarterly loan loss provision estimates.
But there can be outside factors that throw off the estimates too. Let's say after banks report second-quarter earnings, net charge-offs again stay flat from the first quarter despite the big jump in the loan loss provision. How could that be?
Well, we've had unprecedented intervention from the federal government, including banking support efforts from the Fed, $1,200 stimulus checks for individuals, and the Paycheck Protection Program for many companies. Perhaps these efforts helped bridge people back to employment and financial stability, or they may just merely have pushed the losses off several months.
For the record, I do think net charge-offs will begin to rise in the second quarter, but this is just one example of how the relationship between the quarterly provision and net charge-off levels can help provide insights about what's going on in the broader economy.
Q2 bank earnings reports
First-quarter bank earnings reports told us a lot about how businesses and people were responding to the fallout from the coronavirus. We saw lots of mortgage forbearances, loan modifications, and businesses drawing down existing lines of credit. But Q1, which ended March 31, only included a few weeks of the pandemic's actual impact on the U.S. economy. The second quarter saw three full months of the coronavirus's effects, a large period of which included statewide shelter-in-place orders. So Q2 bank earnings reports should provide a much better and comprehensive view of how certain industries and the broader economy are holding up.