Turning the Corner in Banking – A Wall Street Tale

Wall Street was upbeat in mid-April because the country’s four largest banks (Bank of America (BAC), JPMorganChase (JPM), Citibank (C), and Wells Fargo (WFC)) all reported what Wall Street considered “turning the corner” earnings and all the CEO’s except BAC’s Moynihan were positive on the immediate future.  The data, however, do not lead to such conclusions.

Profits rose at two of the big four.  C’s profit rose to $4.43 billion in I/10 from $1.59 million in I/09.  Believe it or not, C’s profits were the highest reported among the group despite the fact that they have been selling off many of their most lucrative businesses, like the Smith Barney brokerage unit.  At JPM, profits rose to $3.33 billion from $2.14 billion in I/09.  At BAC and WFC, profits fell.  The $2.5 billion profit at WFC was 16% lower while BAC’s $3.2 billion profit was lower by 25%.

Sources of Profit

The basic source of profits at all four of the institutions was their proprietary trading operations (75% at JPM, more than 50% at BAC, and 40% at WFC).  No wonder there is such a furor over the proposed Volcker rule (restrictions on proprietary trading) in the financial reform legislation.

The health of the industry is often measured by top line revenue growth.  Using this measure would not lead to the conclusion that the industry is “healthy”, as at three of the four, top line revenue fell from year earlier levels.  At C, top line was down 5.8%.  It was the lowest in four quarters at WFC, and it fell 11% at BAC.  Only at JPM did top line rise (5.0%).

Asset Quality

As measured by asset quality, the basic banking function was still in the doldrums.  C said its charge-offs were higher.  At JPM, defaults were at an all time high, and mortgage defaults continued to rise.  The $131 million loss in JPM’s retail banking unit was much lower than the $474 million profit a year earlier.  Only credit card losses of $303 million showed improvement over the $547 million loss of I/09.  That’s not a lot of evidence to indicate that “this would be the makings of a good recovery” as suggested by Jamie Dimon, JPM’s CEO.

At WFC, the charge-off percentage was a high 2.71% versus 1.54% a year earlier, and equivalent to the charge-off percentage in IV/09.     This is surprising.  Normally, in a bad earnings year like 2009, a bank writes-off everything it can in the fourth quarter so that the next year looks better.  This is known as a “kitchen sink” quarter.  The fact that the charge-off percentage continued at the “kitchen sink” rate in I/10 indicates that asset quality has continued to deteriorate and has exceeded management’s expectations embedded in their fourth quarter estimates.  This should be of concern to the marketplace.

Charge-offs at BAC were quite high at 4.44% ($10.8 billion) in I/10 compared to 2.85% ($6.9 billion) a year earlier.  In addition, they rose sequentially from IV/09 (3.71%).  And 30 day delinquencies, the precursor to charge-offs, now stand at a whopping 8.5% of the loan portfolio.    Again, the market should be concerned with such deterioration.  At JPM and C, I/10 charge-offs were only slightly better than those in IV/09 (C: 1.14% vs. 1.17%; JPM: 4.83% vs. 5.27%).  How the senior executives of these institutions can be upbeat about these figures is puzzling.

Misleading Provisions

One of the ways banks manipulate their earnings is through the addition or non-addition to their loan loss reserves.  This used to be a fairly simple calculation, but over the last few years this has become a complex algorithm which, while it looks very precise and detailed, it is based on assumptions and judgments which can be manipulated to achieve desired results.  So, earnings have to be examined in light of loan quality and the provision for loan losses.  At C, while charge-offs were higher and no real improvement occurred in asset quality, the provision for future losses fell 16% from I/09 and 5% from IV/09.  At JPM, the provision fell by 30% to $7 billion from $10 billion.  Without this $3 billion reduction, the $3.33 billion of profitability would have all but disappeared!  WFC’s provision of $5.33 billion was higher than the $4.56 billion of I/09.  While it was slightly lower than the $5.91 billion of IV/09, WFC clearly sees significant loan issues ahead.  BAC’s loan loss provision fell to $9.8 billion from $13.4 billion in I/09, a $3.6 billion reduction.  With delinquencies and charge-offs at all time highs, a $3.6 billion reduction in provision casts doubt about the quality of the $3.2 billion profit.  After all, without the provision reduction, profits here, too, would be significantly lower.

Other Economic Indicators

Loan delinquencies and foreclosures are at record highs.  There are at least 18 more months of foreclosures issues as the 5/1 ARMS and Alt-A mortgages of ’05 and ’06 reset in ’10 and ’11.  Yet, despite these facts, loan loss provisions at three of the four were significantly reduced.  The rationality for such reductions would be much more compelling had loan losses and delinquencies shown marked improvement.  But they didn’t.  There may be trends in the internal data that only the banks can see.  But, not all of them see such trends.  WFC, for example, increased their loss provision.  And while BAC provided a whole lot less for future losses indicating an upbeat future, its CEO, Moynihan, indicated that BAC’s loan demand was weak and the mortgage division (which includes Angelo Mozilo’s Countrywide) continued to struggle.

Conclusion

The bottom line is that it doesn’t appear that credit strains have been resolved.  Even if the worst has passed, there still appears to be several more quarters of severe credit issues which will continue to be a huge anchor holding back basic bank profits on the micro level, and economic growth and employment on the macro level.  Only when delinquencies and foreclosures are rapidly declining will the U.S. economy take off.

Don’t be fooled by upbeat CEO statements or irrational market behavior.  The basic business of banking is still troubled.  This, of course, is obvious by the continuing record number of weekly small bank failures.  But it is also obvious in the big bank data when analyzed:

• Most of the profitable revenue was generated from proprietary trading at the big institutions, not from basic banking; and this source is now threatened by the financial reform legislation;
• Top line revenue is still falling;
• Delinquencies and charge-offs remain at record levels;
• The reduction in provision for loan losses, which enhances earnings, in the face of record delinquencies and foreclosures leaves much room for skepticism.

Robert Barone, Ph.D.

April 26, 2010