By John Carney
June 8, 2014 5:40 p.m. ET
When the Occupy Wall Street protesters shed their reliance on homes in favor of camping out, they were unwittingly echoing a titanic shift in the U.S. banking sector.
Loans secured by real estate typically make up about one-third of U.S. bank assets, mostly in the form of home loans and commercial loans. Add in mortgage-backed securities, and the banking sector’s long-term average real-estate exposure rises to 42% of total assets. This climbed sharply in the years preceding the financial crisis, hitting a peak of 48.6% in 2006. Since then, banks have reduced their exposure to debt linked with real estate, due in part to write-downs of bad loans.
The depth of this reduction and its persistence are striking and are critical to judging the valuations of big banks.
Real-estate-linked debt’s share of bank assets has fallen in 24 of the past 32 quarters, according to the Federal Deposit Insurance Corp. At the end of the first quarter of 2014, it was just 38.6%, a level last seen in 1987.
Nowhere is the retreat more evident than in the decline in home loans. Residential mortgages on one- to four-family homes made up about 18% of bank assets from 1989 until 2006. This was relatively constant even as the housing bubble inflated, because many of the mortgages made back then were securitized. At the start of 2014, bank exposure to home loans stood at just 12.2%.
One result is likely to be lower earnings and lower, but more reliable, stock returns in the sector. Rising real-estate exposure before the crisis led to higher returns, and banks that expanded mortgage lending generated higher earnings.
But investors tended to assign a bigger discount to those earnings, so shares of those banks actually underperformed those with less mortgage exposure. That was an indicator of what soon became obvious: The high returns of the precrisis era were earned by raising risk to dangerously high levels.
Today, banks are less exposed to both improvements in housing and any future deterioration. That helps explain why bank stocks rose so rapidly last year amid weak earnings growth. Investors saw the quality of earnings was rising.
That could underpin bank share prices, despite stagnant earnings, provided the trend of reducing risky real-estate exposure continues.
That isn’t a given. One problem is bank executives can’t easily claim credit for earnings premiums arising from this. Making more mortgages, including riskier ones, produces profits investors can see easily. Meanwhile, there is likely to be diminishing returns to further reductions in real-estate exposure. This is harder to do anyway with the sector now far below historic averages. And at some point, banks risk overexposure to other asset types.
All this helps explain why Wells Fargo is cutting its minimum credit scores for loans backed by Fannie Mae and Freddie Mac. FMCC +0.67% Freddie Mac And why Citigroup is seeking to expand purchases of mortgages made by others. Unfortunately for banks, investors might not amply reward any ensuing earnings growth. They have learned to be wary of structures built on shoddy foundations.