Corporate Strategy

Banking on a Recovery

Housing is still out of commission, but the U.S. banking system is back on its feet and helping to move the economy forward.

Michael Austin/The I-Spot

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Economic recoveries usually depend upon a strong banking system and a healthy housing sector. But not this time. Housing is still mired in repair mode and isn’t contributing its typical share to the recovery. For their part, U.S. banks are in repair mode as well — they’re in the midst of major long-term adjustments, in part to adapt to a new regulatory environment — but they are much further along in the process than housing and their European counterparts. “Having recapitalized, stabilized asset values and deleveraged, the U.S. banks are growing stronger and lending once again,”* says Robert T. McGee, director of macro strategy and research at U.S. Trust. “Maybe we can get along without a healthy housing market, for a time anyway, but bank lending is a prerequisite for economic recovery. And the fact is, the economy is slowly recovering. If it happens to be a more sluggish recovery than in previous cycles, it’s also true that the economy is undergoing fundamental structural changes that should allow it to avoid the excesses that led to the last financial crisis and could lead now to a longer, healthier expansion.”

Why It’s Different This Time

“In every business cycle since World War II, the housing, banking and consumer sectors progressively leveraged themselves to higher and higher levels,” McGee says. “In this last cycle, as we all know, the leveraging went too far. This allowed home values to become overinflated. The amount of bad credit extended in the mortgage market became excessive, and the levels of leverage became unsustainable.” As a result, he believes that the current cycle is likely to be the first in which leverage in the banking and consumer sectors doesn’t surpass the peaks of the previous cycle. “Instead,” he says, “we’re in the midst of a long-term structural adjustment in which both banks and consumers are getting their finances in order after a 60-year uptrend in leveraging.”

Bank lending and recovery go hand in hand. Banks both reflect and shape economic recoveries.

And that is what makes this particular cycle unusual. Until now, every economic recovery and expansion was accompanied by a housing recovery — or, if there had been a housing downturn during the broader economic recession, the industry came out of it during the economic recovery. During the 2000 cycle, for instance, when the tech bubble burst, housing managed to do well in many regions throughout the ensuing recession because interest rates dropped so low, and housing was also in the middle of a longer cycle that didn’t peak until several years later. “But that’s changed,” McGee says. “This is the first time we’ll experience a recovery without a significant contribution from housing, at least so far, and that’s made it a weaker recovery as a result. And generally when you have a weak recovery, the weakness occurs in those sectors that need to make longer-term adjustments. In this case, that has meant consumers, housing and banking.”

Housing Still Stuck

“There has been a confusing response from the government over how to deal with the problems in the housing sector, so it’s taking longer than we would have liked to work through them,” McGee says. He notes that housing has been essentially flat for three years. “The sector did pick up when we had credits for first-time home buyers, but it dropped off as soon as the credits were gone. But there are big local differences. Housing recovery has begun to take hold in areas where the foreclosure backlog has been worked through, but we’ve yet to see improvement in areas where that backlog remains in place. Consumer spending is improving, but so far it’s not having a significant positive impact on home purchases.” The bottom line, McGee says, is that though there’s not much chance of a big additional housing drop, “it’s going to take some time — another year or two, perhaps — for housing to regain its footing.”

But U.S. Banks Are Moving Along in the Repair Process

The U.S. banking system, on the other hand, has already made significant progress. “I like to compare it to the tech bubble, when technology stocks became extremely overvalued,” McGee says. “We had excessive expansion and employment in that sector before it all fell apart. Since then, the technology companies have restructured and worked to make themselves healthy, and many are now doing quite well after a severe recession. That restructuring toward health is what is happening in the banking sector now — at least the U.S. banking sector.

“The U.S. economy is more resilient and capable of change, compared with places like Europe and Japan, so we’re seeing the U.S. banking system emerge faster from its downturn than the Japanese banks did from their banking crisis, or the European banks from their own current banking crisis — and now from Europe’s sovereign debt issues.”

The Federal Reserve and the U.S. government — via the TARP program — have been much more aggressive than anything we’ve seen from Europe, McGee says. These proactive measures have been possible largely because of the hard lessons learned in the 1930s about how to deal with a severe financial collapse (indeed, that was the last time the banking system was in such weak shape during a financial crisis). “The Fed’s first quantitative easing program, for instance, saw the purchase of a trillion dollars’ worth of mortgages, and this was a key reason why the asset base — the value of those mortgages on bank balance sheets — stopped declining. As a result, many in the U.S. banking sector are now in a better position,” he says. “By contrast, in Europe, there’s no unified central authority, just different countries that have to agree, and that’s led to a weaker, more reactive approach to solving problems.” While many of the U.S. banks have grown stronger since the financial crisis, Europe’s banks have only grown weaker, and now they’re facing a serious financial crisis of their own. Says McGee: “The U.S. banks have recapitalized, their asset values have stabilized, they’ve deleveraged. They are lending again and contributing to the overall health of the U.S. economy as a result. Getting companies, particularly big companies, to invest in things like new plants, technology and R&D is a way to grow jobs and get the economy moving, and strong banks are critical to the process. This stands in sharp contrast to Europe’s banking system, where leverage remains much higher than in the U.S., they are undercapitalized, and their asset values still need to be marked to market much lower.”

Interestingly, McGee notes, Europe’s banks have been important for lending to emerging markets. “This creates an opportunity for U.S. banks. While consumer borrowing in the United States won’t grow as strongly as it has in the past — U.S. consumers have essentially reached the limits of their leveraging — there is an opportunity for U.S. banks to provide financing to consumers in other parts of the world.”

At the same time, the lending environment is improving in the United States. “Consumer borrowing — in areas other than housing — is beginning to improve,” McGee says. “And commercial lending has shown a normal cyclical pattern where initially companies have excess cash because they were cautious and conservative during the recession, but as the economy recovers they reach a point where they start borrowing to finance their investment and expansion. That’s been happening for about a year now.”

A Slower, Healthier Recovery

“Maybe we can have an economic expansion without a substantive, or at least immediate, recovery in housing, but I don’t know of any business cycle where you didn’t have an expansion of bank credit into the overall expansion. The fact is that bank lending and recovery go hand in hand. Banks both reflect and help shape economic recoveries. And that is exactly what’s happening now,” says McGee. The banks may not be seeing much growth in home mortgage lending, but they’re also stronger than they were a couple of years ago; they’re seeking growth opportunities and lending in other areas — and thereby are aiding the broader economic recovery. “Looking ahead, it may be true that banks aren’t likely to grow as fast as they did in the past. In addition to increased regulatory scrutiny (which is likely to place constraints on banks’ ability to grow), U.S. consumers aren’t likely to seek home loans at the pace they once did, and those who do will need to demonstrate the ability to repay them. But that’s all to the good. It should allow us all to avoid the mistakes that led to the last financial crisis and permit a healthier, more sustainable expansion.”

*Federal Reserve Bank lending statistics, 2009 through January 2012.