JPMorgan Issues Bearish Warning For Midsize Banks

bank sector

From Brad Hoppmann: A deposit drain is coming. So, merge while you can.

That’s the advice JPMorgan Chase & Co. (JPM) has for regional banks, as reported this week in Bloomberg.

The story outlines the investment bank’s prescription to smaller banks on how to survive what it sees as a crunch that’s coming in December. A crunch that’s coming thanks to the Fed’s bond-buying program.

The Bloomberg piece cited a confidential presentation obtained by Bloomberg News, and subsequently confirmed by a JPMorgan spokesman.

Here’s the thesis, pulled directly from the Bloomberg article:

JPMorgan argues that some midsize U.S. banks — those with $50 billion in assets or less — could face a funding problem in coming years as the Fed goes about shrinking its massive balance sheet, according to the 19-page report the New York-based bank has begun sharing with clients.

The Fed’s bond-buying spree from 2009 to 2014, dubbed quantitative easing, inadvertently left the industry flush with deposits. Investors took money they got selling mortgage-backed bonds and Treasury securities to the Fed and parked it in U.S. retail and commercial bank accounts.

But now that the Fed has announced it would cease its bond-buying activity as part of the “normalization” of monetary policy, that could mean this deposit drain is heading toward midsize banks.

After all, as the Bloomberg story goes on to explain, the Fed’s bond-buying created about $2.5 trillion in excess bank deposits.Now, if I were running a midsize bank, I know I would heed JPMorgan’s warning.

JPMorgan now estimates that about 60%, or $1.5 trillion, of that money will likely come out of those regional banks in the next four to five years … particularly “if the Fed follows through with recent guidance and begins reversing quantitative easing in December.”

So, how will this process work?

JPMorgan explained the situation in their presentation titled, “Core Deposits Strike Back.” A clever title, I might add.

The presentation, according to Bloomberg:

… illustrates how this process will sap bank deposits using the example of a couple who pays off a mortgage that was bundled with other mortgages and sold to the Fed. Right now, when that couple takes that money out of their bank account for that payment, the Fed uses that cash to buy another mortgage bond, recycling it back into the banking system.

A “deposit is destroyed” if the “Fed does not reinvest,” the presentation states.

JPMorgan estimates that a quantitative easing-related deposit-drain could result in loan growth lagging deposit growth by $200 billion to $300 billion a year.

It’s the conclusion here that should worry not only those who operate and/or work for regional banks, but also those investors who own regional bank stocks such as those in the SPDR S&P Bank ETF (KBE) and the SPDR S&P Regional Banking ETF (KRE).

Interestingly, both of these bank Exchange-Traded Funds (ETFs) are down year-to-date. (KBE -1.1%, KRE -1.9%) However, over the past 12 months, both are up substantially. (KBE +37.9%, KRE +40.6%).

Could the recent downtrend in regional bank stocks be signaling the looming deposit drain JPMorgan has warned about?

While any deposit drain might be premature, it’s definitely something to consider if you plan on owning regional bank stocks for the long haul.

It’s also something to consider if you own a regional bank that you hear might be looking to partner with another bank in the similar deposit-drain situation.

As history has shown, mergers can be good for some stocks, and bad for others.

So, choose your regionals wisely.

The SPDR S&P Bank ETF (NYSE:KBE) was unchanged in premarket trading Thursday. Year-to-date, KBE has declined -1.08%, versus a 7.31% rise in the benchmark S&P 500 index during the same period.

KBE currently has an ETF Daily News SMART Grade of B (Buy), and is ranked #26 of 39 ETFs in the Financial Equities ETFs category.

This article is brought to you courtesy of Uncommon Wisdom Daily.