Credit cycle deterioration? Not so fast- new earnings reports from the banking sector ease fears of financially stretched consumers and companies.

John Guarnera, Senior Corporate Analyst on RBC BlueBay’s US Fixed Income Team, explores the latest data from US banks and an outlook on recent credit market developments.

• Third-quarter earnings from major US banks revealed stable asset quality and improved credit metrics.
• Banks' balance sheets remain robust, with high capital levels and strong liquidity, supporting their ability to manage potential risks.
• Consumer and commercial credit trends show improvement, with delinquency metrics stabilizing across prime and subprime markets.

Hello and welcome to the latest edition of The Weekly Fix. My name is John Guarnera and I am a Senior Corporate Analyst on both the Investment Grade and High Yield desks here in Stamford.

In the past few weeks, we have endured regular headlines about commercial and consumer lending exposure among various U.S. lending institutions. In the commercial space, announcements from a small number of lenders about their exposure to fraudulent loans and poor collateral management led to questions about whether we were on the precipice of another credit cycle and who was most exposed. In the consumer space, the bankruptcy of Tricolor, a subprime auto lender who was focused on the undocumented market and was accused of fraudulent behavior and double pledging of its collateral, raised fears about financially stretched consumers and pressures on the companies that lend to them. And amidst all this, the largest U.S. banks released third quarter earnings last week giving us an update into the current health of the banking system.

So how do we reconcile all of this data and the recent market volatility?

To begin with, banks’ third quarter earnings could be described as strong and steady. Earnings generally came in better than expected. Profitability metrics improved, net interest margins expanded, and those lenders with investment banking and trading operations benefitted from improved client confidence in the direction of the economy and a subsequent uptick in deal activity. At the same time, banks have been diligent about managing their expenses which has led to improvement in their efficiency metrics. Banks’ balance sheets remain robust with high levels of capital and large pools of liquidity to handle any pending needs.

The biggest focus of the earnings season, however, was on banks’ asset quality metrics and their outlook for credit. The headlines heading into earnings season raised concerns about a deteriorating credit cycle and the potential fallouts from this. Contrary to the speculation of some market participants, banks’ asset quality trends held firm. Loan loss provisions were generally flat to lower, nonperforming loans were steady, and charge offs were generally improved from a year ago. Additionally, the level of reserves against potential loan losses either stayed consistent with previous quarters or in some cases was reduced, which sheds insight into banks’ views about the credit outlook going forward.

For those banks with significant consumer exposure, whether in credit cards or auto loans, the underlying trends remained consistent. Specifically, through a combination of earnings releases and monthly master trust data, we continue to see improvement in delinquency metrics with delinquency roll rates decelerating and charge offs slowing. This was apparent in both the prime and subprime markets helping to allay some of the recent market fears about a deteriorating consumer outlook. To be sure we will continue to watch job formation, payroll numbers, and unemployment indicators over the coming weeks, but for now the outlook for consumer credit feels intact.

At the same time, the outlook for commercial credit also remains good. While there is some concern about banks’ broader exposure to non-depository financial institutions, this has yet to show up in their asset quality metrics. Banks showed no obvious signs of deterioration within their commercial loan books and even those banks that noted exposure to the recent fraud discoveries highlighted steady performance within the rest of their portfolios. This leads us to believe that these fraudulent activities are likely idiosyncratic and not part of a broader deterioration in the commercial credit markets. In this space we will continue to be mindful of banks’ underwriting practices and lending concentrations but for now we see no obvious signs of a broader weakening or contagion.

As always, thank you for listening, and good luck trading.