In Back to the Future 2, antagonist Biff is able to amass a huge fortune by making sports bets based on a book of game results from the future. The plot of the movie follows the efforts of Marty and Doc to retrieve the book and prevent Biff's ascension to wealth and power.
Reality is, of course, much different. In the real world of investing, we rely on fundamentals to drive our investment decisions. But that hasn't stopped the Ph..Ds over at Wells Fargo's Economics Group from attempting to build a crystal ball to see the future of banking's most critical fundamental: credit quality.
Credit quality always comes first
Banks are unique in the business world in that the product they sell -- cash via loans -- must be paid back, or the bank will fail. It's for this reason that credit quality -- the likelihood of repayment of the bank's loan portfolio -- is the first and most critical fundamental of commercial and consumer banking.
Investors, economists, and also prognosticators look to these measures to assess the health of individual banks, as well as the industry as a whole. The preceding chart shows the clear improvement industrywide since the financial crisis, and the following table shows the same trend among four well-known regional players.
Loans 30-89 days past due as a percentage of assets
With this knowledge, economists over at Wells set out to find economic indicators that could be used to predict changes in credit quality trends. The answer they found is ... the labor market.
Using statistical techniques beyond the scope of this article, the economists were able to find not only a correlated relationship, but a causal one as well, between labor market trends and credit quality trends.
Starting with the basic unemployment rate, they created a new index they coined the "Labor Market Index" (you have to appreciate the creative wordplay in economic reports, right?). It includes six measures of employment:
- Nonfarm payrolls
- Labor force participation
- Unemployment rate
- Average hourly earnings
- Initial claims for unemployment insurance
- Average weekly hours
They found this index was highly correlated to charge-offs and delinquencies at banks. Even more interesting, they found there is a statistically significant causal relationship from the Labor Market Index to the delinquency rate for loans. This causal relationship doesn't exist when tested using the unemployment rate alone.
Does this mean we now have a crystal ball to strap on to our DeLorean?
It all sounds cool, but unfortunately, it's nothing groundbreaking.
This relationship simply shows that when more people are working in better jobs, loans are more likely to get paid. This truth is incredibly logical; you probably knew this already without any advanced statistics or econometrics.
It does not predict earnings, capital, or stock price movements. It's just another tool in your toolbox to understand the economic environment in which a bank operates. And in that sense, the conclusions of this report add some color to the near-term future for the banking industry.
The Labor Market Index is on a very positive trend. It's a leading indicator of credit quality; therefore, it follows that we should expect to see delinquency rates continue to fall.
That's great news for banks like BB&T and Huntington, as lower delinquencies allow them to free up reserves, allocate more capital to growth, and focus on helping customers instead of resolving problem loans.
If you're an investor in Synovus, Regions, or any other U.S.-focused bank, keep an eye on the labor market as 2014 progresses; it will probably have a sizable impact on the whole banking sector.
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The article Discovered: Crystal Ball That Predicts Bank Losses. Here's How to Use It Today originally appeared on Fool.com.Fool contributor Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo and owns shares of Huntington Bancshares and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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