R. Christopher Whalen
Oct 15, 20237 min
October 16, 2023 | Premium Service | Bank earnings began in earnest Friday with reports from JPMorgan (JPM), Wells Fargo (WFC) and Citigroup (C). Each was notable for different reasons. Below we discuss Friday's results and also the implications for Goldman Sachs (GS) and Morgan Stanley (MS).
Of note, our interview Friday with Yahoo Finance about the Fed’s bank capital proposal is below. We noted in our conversation with Nicholas Jacobino and Julie Hyman that Fed Vice Chairman Michael Barr and other US regulators have managed to piss off just about everyone in the housing market. This is one of several reasons why we suspect that the latest Basel III proposal is going to be DOA on Capitol Hill.
Bank earnings so far can be best described as cautiously mediocre. JPM managed to get net interest income to rise sequentially, something that other banks are unlikely to achieve without buying a dead bank. Revenue was down 5% sequentially, however, but JPM continues to show big growth looking at the year-over-year comparisons including First Republic (FR). Excluding FR, for example, JPM’s loans grew only 2% instead of 17% with FR. Ex-FR, average deposits were also down.
We noted on X this week that JPM was really the only possible buyer for FR, first because JPM was the warehouse lender to the CA based loan production shop. As with Bear Stearns, JPM financed and cleared for FR. The San Francisco bank was really more nonbank than depository, making a large part of its profit on originating and selling jumbo residential mortgages.
Some may take offense to JPM CEO Jamie Dimon profiting from this failure, but JPM has been triaging dead nonbanks since 1907. When the Knickerbocker Trust collapsed and there was no Federal Reserve, President Theodore Roosevelt tasked the House of Morgan to clean up dozens of dead trust companies using cash from the Treasury. The large banks have always consumed the net assets of failed smaller banks.
The big positive for all three reporting banks on Friday was lower credit costs with provisions expense down or at least rising at a slower rate. Consumer credit exposures continue to normalize, but are not quite ready to explode despite the intense expectation among the media and allied pundits. The chart below is from the Q3 2023 earnings report of JPM.
Of note, JPM’s efficiency ratio rose to 55 from 49 last quarter, another indication that the salubrious effects of the FR transaction will not last forever. Even as the House of Morgan reports another respectable quarter, the looming prospect of higher bank capital regulations is reportedly making JPM and other lenders look to push down “risk weighted assets” to minimize the need for raising more capital. JPM is reported to be seeking to sell or securitize loans over the next several quarters, although a yet there is no sign of balance sheet shrinkage.
JPM's negative accumulated other comprehensive income (AOCI) increased from -$14 billion to -$17 billion in Q3, this even as the bank aggressively sold securities and continued to report losses in this area. JPM held $580 billion in investment securities and $1.3 trillion in net loans and leases at Q3 2023. If you haircut the $1.8 trillion in securities and loans total by 20% to reflect the movement in interest rates, the mark-to-market loss is over $370 billion or roughly equal to the bank's book equity.
At Citigroup, net interest income was down slightly as interest expense rose 12% vs 7% for interest revenue. Provisions for credit losses were up only single digits. The reserve build by Citi slowed 30% vs Q2 2023, illustrating the fact that the consumer recession predicted by many has yet to occur. Flat expenses and a $500 million surprise in principal transactions helped Citi to beat the Street’s admittedly modest predictions with net income up 21%. Net credit losses rose only 9% but were up 85% YOY. Net income was up 22% sequentially but only 2% compared with Q3 2022.
The income surprise at Citi is most welcome, but CEO Jane Fraser still has many miles to go to get the bank back into good graces with institutional investors. Citi’s efficiency ratio was 67% in Q3 2023 or 12 points above JPM. To get the bank into the low-60s in terms of operating leverage, where it will be possible to attract more institutional support, Citi needs to reduce headcount another 10% from the 240,000 employee total. But, to the contrary, Citi’s expenses were up 5% YOY in Q3 2023.
Negative AOCI at Citi increased to $46 billion in Q3 2023, up just 1% from the previous quarter. Citi reported $508 billion in total investment securities and $648 billion in net loans and leases. If we haircut the $1.2 trillion total by 20% to reflect the move in interest rates the -$231 billion negative balance exceeds the bank's book equity of $190 billion as of September 30, 2023.
WFC saw net interest income fall slightly in Q3 2023, continuing a trend that goes back more than a year. Sell Side analysts and media like to tell themselves that higher interest rates benefit banks, but in this cycle that does not seem to be the case, especially when you look at the sequential comparisons. Interest income was up 6% vs Q2 2023 but interest expense was up 17% sequentially. Historically, rising interest rates tend to see book value of equity fall, as the chart below illustrates.
WFC reported an efficiency ratio of 62% in Q3, seven points above JPM but very much improved over the past year from 73% in Q3 2022. The bank’s balance sheet actually grew slightly vs Q2 2023, but mortgage banking income was less than half the levels of a year ago. Home lending was down 14% YOY due to a decline in mortgage banking income driven by lower originations and lower servicing income, which included the impact of sales of mortgage servicing rights.
WFC has largely withdrawn from residential correspondent lending and is now the second largest mortgage servicer in the US after JPMorgan. Loans serviced for third parties fell over $100 billion YOY to below $600 billion in Q3 2023, reflecting a strategic withdrawal from mortgage lending and servicing. WFC once controlled one third of the residential loan market.
WFC’s net interest margin shrank for the third quarter in a row to 3.03% vs 3.20 in Q1 2023. Net interest income for the nine months ended in September was up 26% vs 2022, but with income growth decelerating. Interest income was up 72% over the past nine months but interest expense grew 381% during the same period.
Provisions for credit losses at WFC were down 30% in Q3 2023 vs Q2, reflecting the broader trend in the industry. Over the nine months ended September, provisions were up more than 600% vs the same period in 2022, reflecting the continued normalization of credit losses, as shown in the chart below.
WFC stated on Page 3 of its earnings presentation: "A decline in accumulated other comprehensive income driven by higher interest rates and wider mortgage-backed securities spreads... resulted in declines in the CET1 ratio of 8 bps from 3Q22 and 16 bps from 2Q23."
In Q3 2023, WFC reported AOCI of -$15.9 billion, which in relative terms is larger than JPM. If we take $928 billion in net loans and leases, plus the bank's securities portfolio at $490 billion, and adjust the $1.4 trillion total by 20%, the result is a mark-to-market loss of $283.6 billion or $100 billion more than the bank's book equity.
Outlook for MS & GS
It is difficult to compare JPM, WFC and Citi to GS and MS because the businesses are so very different. Whereas the large commercial banks have significant unrealized mark-to-market losses on their portfolios, GS and MS do not. Looking at the results for these three banks, the results suggest that the capital markets side of the major banks will be weak as GS and MS report this week.
Citi, for example, saw revenue for its institutional clients group up just 2% sequentially and 12% vs Q3 2022. JPM saw investment banking up vs Q2 2023, but principal transactions and commissions fell and non-interest income overall was down sequentially.
WFC was the surprise of the three, with investment banking fees and gains from trading activities up by double digits, but mortgage banking flat compared with Q2 2023. Investment advisory fees, the single largest component of non-interest income at WFC, rose slightly even as the bank continued to shed assets under management.
Another key indicator for both GS and MS is the investment bank Jefferies Financial (JEF), which reported earnings for the quarter ended August 2023 last month. JEF saw asset management fees rise nicely in the third quarter of its 2023 FY, but the single largest increase was interest revenue. The table below shows the results for JEF.
Investment banking revenue was down 30% during the first nine months of the JEF fiscal year, but principal transactions doubled. Interest revenue is now the largest revenue line for JEF, even larger than revenue from investment banking. Look for similar results from GS and MS this coming week. Notice that interest earnings rose 180% in the most recent quarter for JEF compared with 2022, but interest expense rose 167% over the same period.
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