There are certainly a lot of reasons to like the financial sector right now. For example, banks are much better capitalized than they were before the financial crisis, and they have shed a lot of the bad assets from their balance sheets. And most companies in the sector still trade for historically low valuations.
It's tough to make a case against the Financial Select Sector SPDR Fund (NYSEMKT:XLF) -- if the economy continues to grow, unemployment continues to drop, and the stock market keeps rising. However, if the U.S. economic recovery slows down, it could be bad news for the sector and its investors. Here are a few scenarios that could wreak havoc on the financial sector.
Another lending bubble could burst
The good news is that banks seem to have learned their lessons with mortgages. The credit standards to get a home loan are very stringent right now. In fact, according to the latest Ellie Mae Origination Report, the average credit score for an approved conventional purchase mortgage is 755, well within the realm of "excellent credit."
However, the same can't be said about other types of loans, particularly auto loans. In recent years, the number of subprime loans (with credit scores of 550-619) and deep subprime (with credit scores under 550) granted has skyrocketed to the point that The Washington Post has suggested that subprime auto loans may represent a bubble.
In the second quarter of 2014, subprime borrowers accounted for 12 million active auto loans, or almost 20% of the total, and the rate has been rising. In 2013, 27% of new loans went to subprime or deep-subprime borrowers.
These loans often carry extremely high interest rates of up to 19%, and dealers may even charge more for the car, which produces high payments for the borrowers. These jacked-up prices mean that these borrowers are likely to be immediately "underwater" on their auto loans, owing more than the car is worth. As we saw when the housing market came crashing down, when borrowers are underwater, they are more willing to just walk away when times get tough.
If a significant spike in auto loan defaults occurs, it may be very bad for the banks.
Unplanned litigation expenses
Most of the lingering legal mess left over from the financial crisis seems to be over and done with. For many banks, the largest legal settlements so far have stemmed from lawsuits from the Federal Housing Finance Authority and the U.S. Department of Justice.
In the largest cases, Bank of America agreed to settle for $9.3 billion with the FHFA and more than $16 billion with the Justice Department, while JPMorgan Chase agreed to pay $13 billion to settle charges related to the sale of mortgage-backed securities in the pre-crisis years. As of this writing, 16 of the 18 banks the FHFA sued have settled.
However, not all of the bad mortgage-backed securities leading up to the crisis were sold to Fannie Mae and Freddie Mac. Nor was the sale of mortgage-backed securities the only bad behavior being committed by the banking industry at the time.
In short, there are many scenarios in which we could see additional legal action brought against the banks. And whatever lawsuits that happen from here on out are likely to pale in comparison to those already settled, we can't be 100% certain.
Rising interest rates could hit banks' lending profits
There has been talk of the Federal Reserve raising interest rates for some time now. Quite frankly, I don't see it happening anytime soon to any significant extent. The Fed is scared to death of derailing the economic recovery and will err on the side of caution when it comes to rates.
However, it's pretty safe to say that rates will eventually rise. And when they do, the banks could see a sharp decline in lending activity, which would lead to a huge drop in profits. About 28% of the Financial Select Sector SPDR Fund's holdings are made up of the "big four" banks -- Wells Fargo, JPMorgan Chase, Bank of America, and Citigroup -- while smaller banks make up a lot of the fund's remaining holdings. As a result, a sharp decrease in lending could hit the fund hard.
Likely or not, it's definitely possible
I don't think any of these three scenarios are especially likely, at least in the near future. However, under the right (or wrong) economic circumstances, they are definitely possible.
Interest rates are more likely to rise slowly and steadily at the hands of a cautious Fed. The major litigation against the banking industry is likely in the past. And so long as the recovery stays on track, we're not terribly likely to see a spike in auto loan defaults. Even so, when considering any investment, it's important to be fully aware of the downside risks, and the financial sector certainly has a few.
Matthew Frankel owns shares of Bank of America. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.