- Mixed commentary, but broadly negative data points across most bank reporting segments.
- The best-positioned banks remain JP Morgan and Bank of America.
- Risk are elevated in Wells Fargo whereas Goldman Sachs and Morgan Stanley have excessive exposure to trading.
Banks are set to report weaker results across Q1’16 earnings. On a broad basis, the issues are primarily tied to loan spreads in the consumer banking segments, softness in trading revenue, and loan loss reserves tied to energy. On the flip side, investment bank volumes picked up but didn’t provide significant relief in terms of advisory revenue, given mega deals capping revenue upside. The broad implications are hard to model but expect weak reports across the universal banking group in the United States with major brokerage houses like Goldman Sachs and Morgan Stanley under heavier stress due to the weak trading environment in Q1’16. I do anticipate that some of the banks will recover more quickly when compared to other banks in the second half of 2016.
The nature of this article is to give everyone a basic idea of where the major banks stand in the upcoming reporting cycle. More specific analysis for JPMorgan Chase &Co (NYSE:JPM) and Bank of America (NYSE:BAC) will be published following the earnings announcements on April 13th 2016 and April 14th 2016 respectively.
As it currently stands, the aggregate performance of banks has shown patterns of softness in mortgage banking due to a decline in average mortgage interest rates for both 30-year and 15-year loans. The mortgage spread declined, which implies slightly weaker net interest margins (the difference in a bank's cost of borrowing versus the rate at which it lends at). The commentary on mortgages was also weak, as Barclays reported that the MBA (Mortgage Bankers Association) anticipates a 13% decline in origination and refinancing in Q1’16, but will re-accelerate in Q2’16 with 26% growth in originations. On the commercial banking front, investors should anticipate net interest margins to suffer modestly as well.
At least according to Barclays:
In addition, looking at the spread over the intended Fed Funds shows the effective rate narrowing from 193bps to 179bps in 1Q16 as the 11bp increase in loan pricing failed to match the 25bp increase in Fed Funds. In addition, in 1Q16, commercial loan tenures extended, though collateral usage increased to a record high, while the prime-based proportion fell to an all-time low.
The commercial banking segments of major banks have been a soft spot due to energy exposure. However, quality has declined to some of the lowest levels seen in quite a while. The commercial loan duration has extended, and the increase in rates did not offset the 25 basis point increase in Fed Funds. I don’t anticipate spreads to worsen too significantly as the Federal Reserve is limited in its ability to raise rates for the duration of the year due to the macro policy of other central banks.
Bank of America is expected to net $450 million in securities and investment income. However, this gets offset with $2 billion in total headwinds from restructuring expense, net interest margin contraction, tax credit roll-off and loan loss reserve build.
Citigroup (NYSE:C)) isn’t doing exactly hot either, basically $400 million restructuring cost (due to employee severance), $225 million in loan loss reserve build and $200 million in litigation settlements totaling to $825 million in operating headwinds.
Goldman Sachs (NYSE:GS): $100 million in legal charges, the losses from litigation were more concentrated in FY’15.
JP Morgan Chase near-term headwind involves $575 million loan loss reserve build, and I recall some commentary on corporate tax rate increases due to roll off of credits, but it’s not clear whether it’s that meaningful given extraordinary earnings headwinds in Q1’16.
Wells Fargo (NYSE:WFC) has $800 million in gains due to investments, which confirms the modest improvement to “gain on sale proxy” from the earlier Barclays graphic. Since Wells Fargo has high exposure to mortgage banking, the mark-to-market improvements on its portfolio seem in-line or reasonable with other bank analyst commentary.
In terms of earnings, the headwinds from trading are most concentrated and will have an out-sized impact on the universal banks. Even if trading revenue were to pick up in the back half, the weakness in Q1’16 trading has significant implications for FY’16 results. Credit Suisse summarizes this as -24% EPS impact for Morgan Stanley and -20% EPS impact for Goldman Sachs. It’s probably a really good idea to avoid the major investment banks this year.
The weakness in trading revenue is more subdued for Bank of America, Citigroup and JP Morgan with negative EPS impact of -8%, -8%, and -5% respectively. JP Morgan’s losses seem best contained this year with a more robust capital return policy in play ($3.18 billion in Q1’16), i.e. the bank remains the best house on a bad street.
While M&A volumes picked up in Q1’16 due to mega deals, it seems advisory revenue is mostly down across the group. The banks expected to escape with the least damage were Morgan Stanley (27% y/y growth), JP Morgan (16% y/y growth) and Bank of America (18% y/y decline). Given my equity coverage on Bank of America and JP Morgan, I feel slightly more confident in investment banking and advisory fees coming out of Q1’16.
Source: Alex Cho, Yahoo Finance
High-level overview: the banks with the least risk include Wells Fargo, JP Morgan and Bank of America (in that order with some caveats) when based on current consensus estimates.
Wells Fargo has had the lowest number of revisions going into Q1’16 due to lack of trading and investment bank exposure. However, the bank has other headwinds in consumer lending due to narrowing spreads and lower quality commercial/consumer loans. There's limited upside to fee income growth in consumer banking. As such, I think estimates could prove to be a little too aggressive given contrarian calls on Wells Fargo from UBS. On the plus side, Wells Fargo has significant mark-to-market adjustments/gains to its portfolio when compared to other banks. However, this partially gets offset by a $1.2 billion settlement for mortgage deception with timing of payments indeterminate.
Bank of America and JP Morgan Chase have gone through enough analyst revisions to help diminish “expectation risk” going into the quarter. Virtually every bank analyst anticipates both companies to report declining EPS metrics, which runs counter to JPM’s long-term estimate of 12% EPS growth due to net interest margin expansion, cost reductions and consumer loan growth. I anticipate the bank to re-accelerate going into FY’17 though, as the patchiness to results is mostly market driven.
In the case of Bank of America, investors should get more aggressive coming out of the report, as the bank is a lot closer to reaching its capital return objectives, cost reduction target and CET1 (common equity tier 1) objective. I’ll have more definite commentary on Bank of America. But, given limited portfolio exposure to oil and efforts to reduce cost being highly predictable, there’s still some upside to results. Furthermore, Bank of America escaped the quarter with decent M&A deal flow and has a less risky loan portfolio when compared to Wells Fargo. So, following this quarter the risk-to-reward should look a lot better, but investors should wait for earnings results before initiating another position.
Finally, I would avoid Goldman Sachs, Morgan Stanley and Citigroup stocks until the trading/investment banking environment stabilizes.