(This transcript has been edited for clarity)

Total time: 11:12

Roman Samuels: Welcome back to the Sage Advisory podcast. My name is Roman Samuels. I’m here with Ryan O'Malley, and today we're going to talk about regional banks. But before we get into that, tell me what's going on the U.S. economy right now.

Ryan O’Malley: So the U.S. economy is firing on all cylinders. Everything is kind of going exactly as the Fed would want it to go. Unemployment is near historic lows. The levels vacillate a little bit, but we're adding 150,00, 200,000 jobs, nearly every month; employment claims are down. We're right around the 2% growth rate for GDP. The Fed notably recently revised their inflation target from 2% flat, to anywhere from 1.5% to 2.5%. That's notable because what we're thinking here is that they're now a little bit more okay with a little more inflation than maybe they got it to in the past. Remember, their dual mandate is to manage inflation and also unemployment. The unemployment’s taken care of. And that doesn't sound like a lot but moving from 2% to 2.5% at the upper bound means that you can suffer a little bit more inflation and therefore, the balance sheet unwind has been pretty much at this point talked to a halt by sometime in September, October. So that's really great for risk assets.

1:13

Roman: Okay. So things are good. Things are moving in the right direction, we have kind of this rosy backdrop. However, there seems to be this segment of the market that's coming under some pressure. And that would be regional banks. So tell me a little bit more about before we dive into what's occurring there – what do we mean by regional banks?

Ryan: So you know, there's a couple different ways to look at the banking sector. But what we're talking about here is you have sort of, two large groups of large banks. They're all large, but on the one hand, you have the “money center banks,” and that would be your Citi Banks. You know, Bank of America, JPMorgan Chase, guys like that. They have huge investment banking arms, and they have commercial lending arms, they are huge in everything they do. They're very important, no doubt about it. But they're kind of a rare breed because there's only so many of those, and they're systematic. Those are the “too big to fail” guys you are used to hearing about. A tier below those that are still important to the economy but just not quite as big in absolute terms would be your regional banks. That's what I’m referring to here. So this is, think of out of Alabama Regions Bank, Citizens Bank, Huntington Bancshares out of New York -- guys like that. They're not doing investment banking.

Roman: SunTrust.

2:23

Ryan: And SunTrust. Exactly. So SunTrust actually has an investment bank. But most of these guys are, by and large, not doing investment banking. What they are doing is a heck of a lot of commercial loans to small businesses. They are lending to property developers. If you're in Alabama, you probably do have a checking account at Regions Bank and maybe you don't have a JPMorgan account. Here in Texas, we would prefer like a Frost Bank as a regional bank. They're kind of more confined to a certain region, as you would expect. And the reason that is, is because of during the Obama Administration, they made it a lot harder and more onerous from a cost and from a regulatory standpoint to do interstate banking. So you saw a lot of people – like Frost Bank is a pretty large bank, but they decided to dial back and just go in Texas, because they didn't want to deal with the extra cost and regulatory burden of disclosure that were instituted during the, from the SEC, FDIC, during the Obama years. Those rules really haven't been rolled back that much. So they kind of all circled the wagon, so to speak, and went back to where their core regions are. And they realized, especially if you're in certain economies, let's say the Sunbelt, southeast, southwest Texas, there's plenty of growth to be had just by staying in those areas. You don't have to deal with the extra regulatory burden.

3:32

Roman: Got it. So what's going on with regional banks right now?

Ryan: So what they've been doing for the last eight, nine years at this point is they've been lending like crazy, as you would expect, with the Fed keeping rates low for a long time. And also, you know, strength, increasing their balance sheet. There's been a lot of extra liquidity sloshing around. And so these banks have felt very flush. They've had lots of capital to deploy, they've done so. They've gotten great returns on that, and the property markets and the commercial lending market, small

businesses have been firing on all cylinders, like I said before. So they've been very aggressive to try to grab market share. And that trade has worked really well. What's happening now is that there's – I wouldn't say there's anything that's super imminent of concern. But there's a couple things, cracks in the in the dam that are showing that make you kind of pause. And the first thing is the amount of loans they have outstanding is still huge, and it's been growing every year, but the kind of velocity rate of change that has slowed down a little bit. If you investigate why, what you'll see is that the number of, what we call “leveraged loans” that are on their books, has started to pick up marginally – not hugely. Whereas it was 1%, 2% of most people's loan books before, now you're looking at 3%, 4%, or 5%. That's not a huge deal, but it's it because of this aggressive push for market share. They maybe have gotten a little further over their skis than they wanted to. And I think the people that are their credit risk officers of these banks have noticed that the on-the-ground loan officer guys had just been going pedal to the metal, full bore, and now they're kind of being yanked back on the chain a little bit by their bosses.

Roman: Could you tell us for a quick second, what is a leveraged loan? What's important about that?

5:10

Ryan: Sure. So you know, obviously it could be considered a little bit subjective, but there is a definition out there: any loan where the leverage amount, so debt to underlying income or EBITDA, it's four times or greater would be considered leveraged. So this is something in the professional investor world that's become very popular in recent years, because they're floating rate loans there. They are secured by assets. And there are a number of leveraged loans out there that are done in the syndicate via investment bank, and they're traded at the commercial regional bank level. It's a little bit different in that some of these guys they’re syndicating the deals, but they're not necessarily publicly traded. And as such, they’re four times levered. And as long as the credit is okay, that's alright. But the problem is that a lot of these things are not even rated by Moody's or S&P because there’s really no market-based reason to do so.

Roman: Right. There's less scrutiny because they're not public.

6:04

Ryan: Exactly. And these guys can get the deals done. So they say, geez, why should we pay Moody's or S&P or whoever to rate our bond, which is not cheap, by the way – or our loan, excuse me – when we can just get the deal done. So banks are waving these loans in, and that's been great for a while. But now that the risk spectrum is starting to get yanked back a little bit, there's just less information. So it gives you a little bit of pause.

6:25

Roman: Okay, so we've had an environment of the last decade where regional banks have been aggressively lending. And that strategy has been working, they've been getting a lot of return on investment from that. And so these leveraged loans at 4x debt to EBITDA have been pushed out through the door. And what a lot of people maybe don't quite fully appreciate is that alone is a liability to most people, but it's actually an asset to a bank. So now you have these assets going out that are leveraged. And what you're saying is that right now, because we're kind of coming to maybe these late cycle dynamics in the economy, it's a reason for pause, just because they're looking a little less credit worthy than they previously were. Is that what you're aiming at here?

7:06

Ryan: Well, the other way to think about it is that the loan officers have obviously noticed this, or the kind of higher-end risk officers have noticed this. And so then there's a survey out by Moody's and a survey out by the Federal Reserve itself, where in one they surveyed 38 regional banks and other they did 73 domestic banks. And basically what the takeaway was when they asked the people who were the senior decision makers, “hey, how are you feeling about 2019 as opposed to 2018, 2017, 2016, all the years before?” They're now saying, it actually hasn't happened yet, but we're expecting credit quality to deteriorate somewhat, maybe expecting a few more write-offs or things like that, where we hadn't really seen that in recent years. And because of that, we're taking the next logical step here at Sage and saying that will probably likely lead to them pulling back on their lending somewhat. And we see some sort of evidence of that when you look at the month over month change in commercial industrial loans.

The growth rate is slowing down.

8:03

And then the other thing that has us a little bit concerned is when you look at the velocity of the M2 money supply, that has started to tick down a little bit; so lending is being pulled back. And consequently, there's less money out there for developers, small businesses, people like you and me. And then on top of that, the people that aren't getting loans are spending less dollar amount per loan. That's what the M2 velocity measures.

Roman: Got it. So there's kind of two forces at play here. The first is we've had this massive surge in lending. And now we're getting to this point where some of these loans probably aren't as credit worthy as we thought. So the risk officers are thinking, okay, we need to maybe tighten our standards a little bit. What that does is that slows credit in the economy, that decreases the liquidity that's out there. But in addition to that, and I think what you're alluding to there with the velocity of the money supply, is that because we've had such an expansion of credit that it's almost like a law of diminishing returns when it comes to the liquidity that goes out isn't being spent as much.

Ryan: That's exactly right.

Roman: Okay. So we have two main forces here that are that are causing us to say, okay wait a minute, maybe regional banks are a little more exposed than we thought to a slowdown in credit. So given that backdrop, what is Sage doing about that? How do we think about investing in this space?

9:16

Ryan: Yeah, so we're doing as we always do – try to be cautious about where you're putting your bets on. And so I think any sectors of the credit markets first of all that are exposed to this – whether it's real estate or malls or consumer, non-consumer cyclical companies that might be affected. We're dialing that back. We've already talked about it in a previous podcast, I believe. And then the other part of it is, look, this is a this is a bit of a harbinger for confirmation for late cycle, and we've been talking about late cycle for a while, but this is a pretty concrete one. It's not just a feeling in your stomach. This is something where you're getting information from the regional banks, people who I think sometimes are a little bit more on the ground than the big money center bank guys. And little bit more in touch with Main Street, let's say. So that's making us feel like okay, we've had a really good first call, everyone's performance has been great in equities and in bonds, but now's the time to kind of shore up your portfolios and make sure that you dial back the risk a little bit. Take risks where it's appropriate but make sure you're not getting too far ahead of yourself.

10:14

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