The virus credit cycle
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(Scott): Good afternoon and welcome everybody to our conversation with Ben Hesse where we are going to focus on implications for the banking and asset management segments in light of today's environment.
On behalf of JP Morgan I want to thank everybody who dialed in for dedicating time to our market investment calls as well as your ongoing partnership. For sure these are unprecedented times. We look to remain a leader in bringing you timely and impactful information like this call.
So with that I am honored to introduce you Ben Hesse. Ben is our Head of Strategy and Business Development for our asset and wealth management business. And is a member of several of our senior operating committees.
We would say his knowledge of banking and asset management run second to none. Given his work with us as both a PM and heading the investment team for our global alts franchise focused on financial services sector.
Ben has also spent nearly a decade with Fidelity where he managed both a 15 person research team and 7 sector portfolios. He was responsible for their overall positioning in global financial stocks. When I asked Ben his fun fact. His self-admitted fun fact was that as 15 years as a portfolio manager, has done over 8000 company meetings with financial companies.
So now to work with him on some of rounding that out. So self-admitted financial guru. He has a Master’s degree in Business and Economics from Columbia and NYU respectively. In short, it should be a great conversation today. So with that Ben thank you for joining us.
Ben Hesse: Thank you (Scott) and it is great to be here. Great to be here with your clients. You guys do such an amazing job for JP Morgan. By the way, that 8000 company visits does not include grants visits and you can get a lot out of visiting branches even now. You know you can check up city rates. We can see who has got wealth products. You can go and chat with the tellers. So we have a lot of branch visits as well.
It is great to be here and hopefully we can have a great conversation about banking and asset management.
(Scott): Terrific. Thanks for joining us. So maybe Ben just quickly. The transition from your role as PM into heading up strategy and business development. A little bit about maybe what - tell me about that?
Ben Hesse: Yes sure. So for 15 years I was a portfolio manager. Ran a number of different strategies, mutual funds, SMAs and we did something really interesting in December and you don't see a lot of traditional asset managers do this. We actually shut down a strategy and returned the money to investors after 57% net return.
And the reason we did that is because we saw the opportunity in banks that was like such a multi-year opportunity that we are excited about in '14 and '15. We saw that as over. And with this recent pullback a lot of clients have asked me, hey are you going to start a new strategy? Are there banks or financials? And the answer has been no. And hopefully after this conversation you will understand why.
(Scott): Got it all right. So with that then maybe let's jump into first topic around banking and financial services. And maybe start with what have been some of the key drivers of bank profitability in recent years? And how has recent activity, the last month or so changed all that?
Ben Hesse: Great question. So if you look at the last five years, the biggest driver for banks really was the Fed rate increases. So really the Fed started to raise rates in December '15, continued through 2018. That drove a one third increase in net interest income, NII which is $550 billion for the top banks in the country over those five years.
Meanwhile, the other source of revenues which are fees barely increased. So they are up like only 6% over that five years and fees are less than half of NII in terms of overall revenue. So those are the two most important revenue sources. It is also important to know that incremental NII because it requires no additional people is all margin. So it is a very profitable place to be for the industry and that is what happened.
The second biggest driver of higher bank earnings was lower taxes and that was following the corporate tax cut that we saw in the United States in 2017. If you look at the taxes paid by U.S. banks, in 2014 it was $68 billion. In 2019 despite much higher pretax earnings it was only $61 billion. So much lower taxes paid.
The result of those primary drivers was an explosion of earnings and dividends. So earnings for the biggest U.S. banks up from $153 billion to $240 billion over the five years and in 2019. Dividend doubled to $180 billion over that period. Buybacks were more concentrated at the largest banks but they followed a similar trajectory.
This was all the last five years, a golden age for U.S. banks. But then what happened last year, the Fed started cutting rates. They cut three times. Then we obviously COVID hit. Rates started to reverse sharply. Tax near flat for now. We will see what happens over time.
But provision expense, credit cost which have been so benign and which are so important in terms of a driver of bank earnings. Those are also inflecting sharply as I think we will see as bank earnings get (unintelligible) over the next couple of weeks.
The result is, earnings power for banks are facing a lot of pressure. How institutions respond to that will really depend on the levers that each have to pull.
(Scott): Got it. So what type of actions will banks and other financial services firms need to take to adapt given this environment?
Ben Hesse: So there are two things that banks can do in this type of environment. The first is grow their fee revenue and the second is cut expenses. And neither is easy really in my view.
The first is growing fee revenue. If you look at the U.S. banks as I said before had only about $260 billion of fee revenues last year. So half of net interest income. But there are many types of financial services fee revenue pools out there that banks could go after. The biggest by far is wealth and asset management. That is about a $600 billion revenue pool globally. The next one is credit card which is $200 billion.
The next ones though I am going to list a couple of more. Those are really concentrated within the biggest players. So fixed income trading, transaction banking, investment banking, payments, equities, insurance. All those are quite concentrated.
So if you look at the fee pools that are available to most banks. It is really two options. Wealth management or cards. You can put mortgage in that bucket but mortgage is so cyclical I just expect wealth management and card to be the focus.
The second option is to cut expenses and the problem with that this year is that banks are facing really a lot of pressure on expenses either through their no layoff commitments, the regulatory pressure, cyber risk which has really ratcheted up as while working from home. Mortgage volumes, et cetera.
In fact I expect many of the banks in the United States to see higher expenses, higher headcount in 2020 despite what you expect to be the contrary.
(Scott): So we saw continued Fed actions of pushing to muni, high yields. But maybe more generally, all these Fed actions were implications for the banking industry in general?
Ben Hesse: Yes so the Fed itself has done two things. They have cut the Feds funds rate to zero and they have committed to historical level of asset purchases. So low rates is the first one. Many bank to benchmark rates whether it is Libor or the replacements to Libor at prime. They follow Fed funds. Although the spread varies and has been quite wide of late which is a positive.
The Fed is also purchasing hundreds of billions of dollars’ worth of U.S. Treasury and agency securities. This pushes up the value of existing bonds on the bank's balance sheet. But the much bigger negative is that it lowers reinvestment rate for securities.
So as a net result of both the lower Fed fund and the lower securities reinvestment rates is that net interest margins or NIMs are going lower, perhaps much lower. And the way just I am thinking about this as a good rule of thumb is to look back for companies to their 2011, 2012 and 2013 NIM when we saw similar type of asset purchases and also (unintelligible) 25 BIPS before they started raising.
You can look at the net interest margin back then. That is a general good estimate of what 2021 net interest margins are going to look like for the industry in my view. And to get to net interest income which is the revenue source from net interest margin. What you do is you take net interest margin and you multiply it times average earning asset.
And the biggest component of earning assets is loans and loans obviously have grown for most banks since 2013. So what I am saying is NII is not going back to 2013 levels. Revenue is not going back to 2013 levels. But it will drop a lot from 2019.
And so for many banks it is a huge top line headwind. Lastly, within the realm of these asset purchases you have what the Fed announced which is what you mentioned which is that munis and high yields. Now that they have done this, basically these are the last two big asset classes that they hadn't yet committed to purchasing.
So that is obviously positive that the market loves it. They are supporting all of the big asset classes except equities. I am concerned about two things though. First is that market pricing is incredibly distorted relative to the fundamentals.
And then second, that purchase of these risky securities comes with strings attached down the road for corporate America. And maybe we can touch on that a little bit later but those are the two things I am worried about.
(Scott): So what impact then do you think the CARES Act will have? Maybe in particular you can explain what is going on with the SBA lending program as it relates to some of these initiatives?
Ben Hesse: So it is a great question. The CARES Act is the third federal action intended to blunt the impact of this COVID virus. It was signed a couple of weeks ago at the end of March. The first two acts were much smaller and focused on things like vaccine and unemployment benefits.
The most controversial piece of the CARES Act is this SBA piece. Which was $350 billion of lending capacity to small businesses. And small businesses employ 60 million people in the country, of the 165 million or so that are employed. So an incredibly piece of the American workforce.
And I think the intention was to make these loans forgivable if they are used for things like payroll or mortgage interest, rent to basically keep small businesses on ice so they don't fold. So they keep their people employed while we get to a resolution on this COVID situation.
Now there are also in the Act some incentives for small banks especially to make these loans. And in fact it depends on the size of the business and the size of the loan. But banks can get up to a 5% origination fee for making these loans and the interest rates are low as well.
The issue for (unintelligible) and most banks are issuing these loans just to existing customers. The issuers reaching clients from the Treasury is hard so they really need the banks to do that for it to be successful and that is what is happening.
But I do think that just given the size of the problem with small businesses and them facing historic levels of demand destruction. You are probably going to need a bigger program than that and so we will see what happens in the next couple of weeks.
But I also wanted to mention I think something that is even more important that the industry is doing for clients. And this one is something by the way that is not backstopped by the government is these untapped revolvers that are getting drawn by thousands of corporations.
So at the end of February there was about $2.5 trillion of untapped revolvers at the U.S. banking system. Since then you have seen over 20% of that drawn down in just five weeks. Now this compares to about a 30% draw during the entire global financial crisis. So really a big deal and I think a sign of how strong the banks are in terms of the capital and liquidity that they have to support the clients at this time.
(Scott): Okay so we have all these programs out there. You are saying untapped revolvers the banks can get into. But from a credit loss standpoint what do you see potentially in the industry? And if so, what impact may it have on short term and longer term growth in the industry?
Ben Hesse: So this by far the biggest area of focuses for investors and for conference calls that start next week for banks. So if you look, the U.S. banking system has over $10 trillion of loans, about $10.5 trillion. So really the $10 trillion question right now is what will be the cumulative loss rate on that consolidated loan book for the industry?
And I as someone who studied this industry for a long time can tell you the loss rate on every credit cycle in the last four years. Texas Energy in the 80s, New England commercial real estate in the 90s. The tech bubble, global financial crisis. We just had one a couple of years ago and you and I talked about this energy in '15, '16.
But we have never had a virus credit cycle. We have never had a credit cycle where three quarters of the economy is shut down. We have never had a credit cycle where you and I are talking to each other from our dining rooms. We have never had 17 million American workers file unemployment claims in just three weeks. All of these things are unprecedented.
And similarly, you know, to keep it balanced the government's response in this crisis has also been unprecedented. The Fed buying everything as we saw except equities. So modeling these loss rates is really difficult at this point without some guidance from the companies and that is what I think the market is waiting for.
And there are two loan categories in particular that will be in focus. And that is C&I, commercial industrial and credit card. Together they are about $4 trillion of the $10 trillion. So about 40% of the U.S. consolidated bank loan book. It is my personal view that these are the two categories that will be the riskiest this cycle.
And as analysts we have to estimate the reserves the banks will put up on this $10 trillion to cover losses. And if you look at what reserves were. They were about 3% of loans in 2009 and 2010 to cover a cumulative loss rate of about 5% on the U.S. bank industry's loan book during the great financial crisis.
So for the industry as of the year end 2019, reserves were 1.2% compared to 3% in the (GSD) for both '09 and '10. And that 1.2% is on a higher loan book. It is on the $10.5 trillion loan.
So if I assume we need to get to 5% of cum loss of the two years. That is probably $500 billion or so of reserve bills from here that needs to happen okay? So we are talking about $500 billion of reserves that need to go through the income statements of the industry, and that is a really big number.
And as I said before, we have never had a credit cycle like this or a response. So those estimates are all over the map. My personal view is that whatever happens with the virus and the unprecedented unemployment that we are seeing now will be very slow to reverse itself and unemployment has a very high correlation with loss rate especially on credit card and unsecured.
So if you look at just the CBO, the Congressional Budget Office estimates for yearend '21 employment. That is 9%. You know that is in over 18 months. And that is almost as high as the peak of the global financial crisis. So if we have that type of duration and level of unemployment in this country, the reserve bill and the loss rates are going to be quite high. So whatever the Fed does with asset prices in the interim. So that is something to consider.
(Scott): Okay so with that then. In a lower rate environment what should the CEOs of companies and the management teams be thinking about? What will help banks hold up better?
Ben Hesse: Yes so as I explained before. The two pain points for banks this cycle are going to be exposure to lower rates through net interest income which is two thirds of revenue for the industry and exposure to credit risk. So big loan books relative to profitability.
So therefore, banks have higher fees as a percentage of revenue and smaller loan books as a percentage of the profitability are going to be better positioned to weather the storm. And in particular, banks that have high transaction and high trading revenue I think are going to do well this quarter.
We will see if the volatility continues. Have no view on their stocks in particular but in terms of fundamentals I would highlight two companies that have fit that trend and that is Morgan Stanley who said that they had 11 of their most active trading days ever in their history in the first quarter. And UBS which just this morning preannounced a very strong first quarter, well above consensus.
So both those companies have very high percentage of fee revenues as a percent of total and they had do lists quite proactively over the last decade. So it looks like they are better positioned.
Outside of banks what is interesting is payment companies, I think, are also going to do quite well. Volumes are lower right now and especially the very profitable cross border volumes have collapsed and I think will stay low for at least six months.
But on the flip side, the shift away from cash that was happening at couple of percentage point a year is occurring quite rapidly now. And I will say that there is nothing dirtier than cash to touch every day.
And in fact if you look at the Big 4 Chinese banks they were actually burning the cash that was returned to ATMs in Wuhan and replacing it with fresh bills from the central bank. So all of this is very good I think fundamentally for electronic payment companies.
(Scott): Great. So maybe let's turn our attention then to asset management and talk a little bit about what are some of the key secular trends you have seen in the industry over the last three years? And again given current market environment will it change the direction of some of these trends or exacerbate them? How are you thinking about it?
Ben Hesse: So I have put them into two categories. First I would say there are things that were happening will continue and may accelerate and I would say here are a couple of things. First, the need for scale. The need to be attached to a global firm.
Second, that balance sheet really matters. We saw this with a couple of peers with their money market firms. The third is that content is king just in terms of being able to communicate with clients on a regular basis.
Fourth, I also think that this is related. Technology really matters. The firms that were able to adapt quite quickly to work from home I think they are the ones that are really positioned for success in this new world.
The second category is that trends were going on before that might slow. And I would put and this might be controversial. I think the shift to passive belongs in this category. So over the last decade we have seen a relentless shift to passive. Something like 40% of equity AUM and 20% of fixed income AUM are now passively managed.
And the CAGR of that has been like 3x passive growing faster than active. And that makes total sense when everything is going up. In the last two cycles that has been the case. It has really been only the problem area that has lagged. So post the tech bubble it took NASDAQ 17 years I think to get back in the highs. And post the GFC it took banks over a decade to get back to the highs.
But the market overall worked and went up. But post this virus crisis I personally think that there are so many sectors impacted by what is going on that it is going to take the market much longer than the standard three years to regain the previous high on S&P earnings and price. So I think you really need active management to help you navigate that situation.
(Scott): Got it. So what are kind of the key growth areas in the industry? And how do you think the industry will look in 5 to 10 years from now given some of those predictions you are making?
Ben Hesse: So I think there are a couple of growth areas for the next five years. And by the way you can look at our investor day and we gave our view for JP Morgan Asset Management. These are my personal views but we gave our view there.
But the first one I would say is alternatives. The alternatives industry was growing at 8% and that includes hedge funds, private alts. I think that growth rate can continue. Fundraising should be quite strong this year. I also think that there is a lot of dry powder that these alternative companies can deploy at quite attractive levels even though the Fed is buying a lot of different asset classes. So I am excited about alternatives.
I also think that it is one place that clients are going to go for income and that leads me to my second area. Income is absolutely essential. It is something we have been focused on here for quite some time. Clients are going to need income just because of how hard it is to find now. So we talked about the Fed cutting to zero. The ECB obviously has been buying everything. Demographics are such that clients need income.
On the equity side, the S&P paid out $485 billion worth of dividends last year. That is going to be much lower for many reasons. Europe you are already seeing dividend cuts as well. So the dividend picture is going to be quite challenged.
At the same time like you are seeing in the mortgage side on the alts and hybrid side. Forbearance, mortgage waivers. I think that picture is just getting started. So you really need income and I think an active manager to find income is absolutely essential. I do believe we have a great offering there.
And then the third thing I would say is SMAs. Especially tax efficient SMAs. You know retail SMAs have grown at a 10 year CAGR of 11% and the 5 year CAGR of 5%. That is your second highest category growth rate behind ETFs.
You know I have run both mutual fund and SMAs and I have to tell you the client experience with SMAs is just absolutely fantastic. And when we did shut down my strategy in December, the fact that we were able to transfer positions to clients was something that they really like and it certainly helped with the tax efficiency. So those are three areas where I do see a lot of growth in the next 5 to 10 years.
(Scott): Great. Some good ideas there. So maybe another area to touch upon is very big topic leading up to COVID and got a lot of attention, ESG. Obviously probably Europe leading us a bit but it has become a very important topic as well here in the States. Thoughts around that.
Ben Hesse: Yes so one of the biggest areas of debate right now within the asset management industry is what is going to happen to ESG? And ESG was a huge focus of the industry in the year before COVID hit. Obviously it was all the rage in Davos which historically to investors like me has been somewhat of a contraindicator.
ESG strategies though I will highlight have performed very well through this and that is good. But some clients I know are wondering if that is just a function of technology performing well and energy performing poorly or if it is actually that the ESG factors have worked. So I think that is where the debate is.
What I will say is that client interest in ESG even post-COVID continues to be extraordinarily strong. I was talking to one private bank here today and they said that attendance for an ESG call that they just did was 2x what a similar call was just a couple of months ago. So there is a ton of interest there. I think that we should all watch closely what happens with client flows. So far though they remain quite strong post-COVID.
(Scott): Great. So then let me turn our attention to within asset management maybe more the wealth management piece of it. We think about the current environment, the work from home that you mentioned. Also thinking about new ways to do our jobs.
We came into this environment with robo-advisory as a big conversation piece. Thinking back on 2008, we are talking now global financial crisis. One could argue that advisors, you know, the value proposition became stronger than ever as also clients reaching out for guidance. How to navigate difficult environments?
What do you take away from all this? And how should we think about how client interactions may change in the future? How the FA proposition works? Welcome comments on that.
Ben Hesse: Yes, so I think digital interaction is going to be one of the big trends that continues post-COVID. Whether it is robo as the exact form it takes. I am not sure. Obviously Robinhood had some trouble with their online platform but you know the reports I have seen is that some of the other robo-advisors who work at Ameritrade Betterment Wealth Fund actually had seen a strong uptick in new account openings as younger clients get engaged and also highlight our new (unintelligible) JP Morgan.
You know the activity, that new account activity through COVID has been quite strong. So I am encouraged by this. You know one of my biggest concerns with the COVID situation is that you had younger investors now who only have a decade if that in terms of millennials investing have experienced now too of the worst crisis in market history.
So the fact that they are getting engaged and they are signing up for new accounts I think is very, very positive and bodes well for the industry.
(Scott): So maybe a question relevant now across both banking and asset management thinking about M&A activity. Do you see it picking up given depressed share prices? Does the environment slow it? How are you thinking about that?
Ben Hesse: So I am going to answer this and say no and yes. No for banks. Yes for asset management in terms of more M&A in 2020. And for banks, you know, banks are sold and not bought. And my view when I had my bank strategy was that you would see a wave of M&A in 2018, 2019 as management teams saw the need for scale.
But instead what happened is a lot of these companies decided to remain independent. The problem with banks is when you have downturns, management teams get really cautious about their own credit quality and incredibly cautious about competitors' credit quality.
And so you typically don't see M&A at cycle bottoms unless it is very distressed, often government assisted M&A. And that tends to not be very shareholder friendly. And so I actually don't see a wave of M&A in banks this year.
Now asset management is different and I do see a pickup in asset management M&A. And in fact we saw a big transaction announced in both asset management and another transaction announced in wealth management just weeks before the COVID really picked up in the United States.
And the reason is asset managers don't have these credit issues or these balance sheet issues. They have scale issues. Scale is incredibly important for distribution. It is important for our technology spend and it is important for earnings power. And those are really the three things that management teams of asset managers are focused on right now.
So I do think you are going to see as more and more management teams think about those three things. You are going to see more transactions later this year.
(Scott): Great thank you Ben. So what are some of the lessons learned Ben from the 2008 financial crisis that you think we can apply in the current environment?
Ben Hesse: Excellent question. This is something that we are spending a lot of time right now within JP Morgan thinking about. I will answer that with actually three different components because it is a topic I am really excited about.
I think the biggest lesson that I took from running money through the crisis is that bailouts happen fast but the strings attached play out very slowly. And so in March 2009, myself and other investors were really thinking look, the Treasury found a way to recap the banks in 2009 as the bottom.
But what we did appreciate was that those recaps from the Treasury would manifest themselves politically and popularly with Dodd-Frank 15 months later in 2010. And so as I see all these bailouts really across corporate America through what the Treasury and the Fed is doing.
And actually within the CARES Act it is quite prescriptive in terms of the restrictions that companies want to apply for some of these funds that they have restrictions around. Dividends, buybacks, executive compensation, employment levels.
And by the way, this is much, much bigger than the bank. And in fact the banks I don't think they are going to be taking this money. I think it is going to be much bigger slots of industry. So I just think there are going to be a lot of strings attached and maybe the market isn't as focused on that as it should be. And I learned that first hand in 2009, 2010 and 2011.
The second biggest lesson is that an explosion in government debt which we are seeing right now does not necessarily mean hyperinflation is around the corner. And you know in the financial crisis everyone thought that the huge deficits would lead to higher inflation. And in fact with every round of QE after the crisis there was a view that we would have higher inflation. It never happened (Scott).
And in fact, there is a ton of good work out there that shows that as government debt, as a percentage of GDP crosses 100% and starts to go higher, rates actually goes lower and deflationary pressures grows stronger.
So we went into COVID in the United States with outstanding U.S. Treasury debt of about 110% of GDP. I think it is going to be around 125% or 130% of GDP within the next 18 to 24 months or so and that is if we include these programs. If we include weaker tax receipts. If we model out the unemployment that the CBO is expecting.
And in fact we might even get additional programs and additional stimulus which could push that number even higher. So I just think that if we do have that level of debt to GDP I think it is very unlikely that the Fed is going to be raising rates aggressively in 2021, 2022, 2023. And in fact I would study some of the other things that they might do to keep yields low even if we do have inflation tick up.
And that kind of brings me to my third lesson. Which is that the way we do business after a crisis is different than before the crisis. And I think that needs to be incorporated into your thinking as an investor and your earnings estimates and market projections.
So you know in the crisis, in the Great Financial Crisis we were thinking as investors that bank lending would pick up as it had historically done. Instead what happened is the banks were quite constrained by regulation and legislation. And instead what you saw is the explosion in the shadow banking industry.
So think crisis I think people need to look at businesses that will be distributed, industries that will be disrupted, business processes that will change and include this in your projection. So everyone is thinking about how their clients do things in the post-COVID world. Let me give you an example.
You know you mentioned I did 8000 meetings a portfolio manager. Many of those were site visits or conferences. You know you have hundreds of analysts that do this now at JP Morgan. A lot of these meetings now are virtual. In fact there was a big conference two weeks ago in financials where all the meetings were virtual.
Are we going to go back to flying to conferences and walking around hotels to do meetings with management teams when we can all do it much more productively, over webcasts? I don't think so. So then if we do the expenses that maybe are freed up from things like that, and this is just a small example, could be deployed into other things with higher ROI. So these are some of the things we're thinking about at JP Morgan.
(Scott): Terrific. Thank you. All right. (Ben), on behalf of everyone, I wanted to thank you for your time today. Your comments, as usual, were very compelling and we appreciate your insights on the industry. And wishing everybody a safe journey going forward. We appreciate all the time you give to us at JP Morgan and your commitment to our partnerships. So, thank you all and I appreciate your time. Bye-bye.
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