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Critical Facts You Need to Know About Preferred Stocks
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There’s no doubt about it. The COVID-19 pandemic and its resulting effects have completely changed industries, stocks and sectors in profound ways. As we’ve socially distanced, worked from home and moved to virtual shopping/meetings, the economy has been severely impacted. And, for the most part, those impacts haven’t been so good.
A prime example has been the banking industry, and the stocks within the sector.
Thanks to the COVID-19 crisis, banks have been hit on a variety of fronts – from loan repayment concerns to lower interest rates. For investors, the implications are vast and could seriously hurt their prospects for dividends/buybacks as well as capital gains throughout the near term.
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You don’t have to look very far to see the damage that the coronavirus pandemic has inflicted upon both the world’s and the U.S. economy. As the virus spread, states and governments imposed a variety of measures to try to contain its spread and flatten the curve of infections, hospitalizations and deaths. As those measures took hold, the economy responded by essentially collapsing. Unemployment surged, consumers stopped spending and the U.S. economy shrank by over 5% in the first quarter of 2020. This was the biggest GDP drop since the Great Recession and the last quarter of 2008. All in all, the International Monetary Fund’s latest World Economic Outlook (WEO) forecast shows global GDP growth to contract by 4.9% this year.
What’s particularly interesting is the quickness and severity of the collapse. For the major banks, this has all been a huge issue: there are a record number of unemployed Americans, furloughed workers and those employed but forced to work less hours. While new unemployment programs and stimulus cash have provided some relief, many Americans are struggling during the pandemic. This creates an interesting problem for financial institutions.
On the one hand, many customers are finding it difficult to make payments on mortgages, business loans and credit cards. As the chief way the banks make money, delinquencies hurt their cash flows and increase losses. In order to combat this fact, many banks have increased programs designed to provide temporary relief by delaying foreclosures and delaying late fees. While these programs will delay losses further down the road, they do cost the banks money in the short term.
And speaking of costing the banks money, the Federal Reserve hasn’t been helping either.
As the economy collapsed, the Fed enacted several measures to push interest rates lower. Jerome Powell and the FOMC have cut rates, actively intervened in the repo market as well as restarted its quantitative easing programs. This has sent interest rates back to zero, thereby hitting the banks’ major source of profitability – their net interest margins.
Banks are able to make money on the difference between what it costs them to gather deposits and the rates they charge for loans. With rates now trending lower, banks simply aren’t making as much money per loan as they were just a few months ago. At the same time, with rising economic strife, overall deposit balances have dipped. This has exacerbated the problem and hit banks’ earnings.
As the major banks have been forced to navigate a new normal, their situation may not be as much of a struggle as before, because the sector is now far better equipped to handle the current downturn.
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Right now, the major banks are far better capitalized than they were during the last recession. Thanks to regulation and overall economic health of the last decade, banks are sitting on much higher levels of common equity capital. We’re looking at levels of 12 to 14% today versus just 6 to 7% before the Great Recession. Secondly, overall loss reserves and liquidity buffers are sitting at levels historically not seen before. All in all, the largest banks like J.P. Morgan (JPM) or Bank of America (BAC) hold an average of $1.3 trillion in common equity and $2.9 trillion in high-quality liquid assets.
Meanwhile, the central banks and other government organizations are providing even more liquidity and funding for the banks. The Treasury, Small Business Administration (SBA) and the Fed have opened their checkbooks and provided capital for the banks to lend to small businesses and consumers.
Finally, the banks are also better equipped to handle long-term closures. Thanks to recent moves into fintech, online operations and mobile deposits, many of the big banks have been able to keep consumers happy. This shift to mobile and digital banking has allowed many businesses and consumers to realize cost savings and reduce overhead.
In the end, the big banks are much better equipped than during the last crisis.
And the banks should be able to keep this going. According to consultancy firms McKinsey and Oliver Wyman, there’s plenty the banks can do to keep the economy going and help their own bottom lines, including measures like increasing the use of internal stress testing and supporting hard hit sectors such as retail and consumer discretionary businesses, while adding less modifications to the better-performing sectors. Banks should also prepare for the idea that the pandemic will last a long time, and work this into future planning and loan varieties.
Secondly, adopting a “digital first, branch second” strategy will be key for the future. This could mean investing in new fintech channels, closing branches and shifting resources online.
Finally, with compressed net interest rate margins, banks should look toward other services such as brokerage, asset management and insurance to drive future gains.
There’s no doubt that the banks have been hit hard by the COVID-19 crisis. The severity of the pandemic has shifted with time on a variety of fronts. However, the effects may not be as bad as first feared. The sector has better firepower and is more readily able to navigate the tough environment. Better still, there is plenty of opportunity to keep it going into the future and during new crises faced down the road. Investors should feel safe owning the bank stocks today.
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