Q1 2023 Bank Earnings: Lower for Longer | JPM USB C WFC BAC

April 12, 2023 | Premium Service | In this issue of The Institutional Risk Analyst, we provide a pre-earnings look at the top-five depositories – JPMorganChase (JPM) at $3.6 trillion in total assets, Bank of America (BAC) at $3 trillion, Citigroup (C) at $2.4 trillion on balance sheet, U.S. Bancorp (USB) at $670 billion and Wells Fargo & Co (WFC) at $1.8 trillion.

As the quarter ends, there is good news and bad news, as we discussed in our previous comment ("Powell's Duration Trap, Banks and the US Treasury"). Yields on loans and securities are rising, but more slowly than hoped. LT yields are falling, in fact, because the FOMC refuses to sell securities from the system open market account (SOMA).

Market analysts come up with a variety of clever explanations as to why long-term interest rates are falling, but the gorilla dancing in the center of the room is $20 trillion or so in option-adjusted duration festering, unhedged and passive, on the Fed’s sterile ledger. Imagine where the 10-year Treasury would be today if the FOMC mandated that the Fed of New York bond desk sell sufficient MBS each month to hit the $35 billion cap for runoff.

In Q1 2023 earnings, effective hedging strategy or lack thereof will feature prominently. Fed officials have no idea how to quantify their market intervention and banks likewise are left with an insoluble risk equation. To the more attentive, since Q3 2022, the trade has been long duration, as evidenced by the decline in the fair value of mortgage servicing assets (MSRs). The fact that price multiples for MSRs continue to climb even as valuations fall illustrates the pain felt by many issuers still operating in the forward loan markets. If the 10-year retraces to 3% or lower in this cycle, margin calls on negative duration MSRs and short-TBA positions in residential mortgages will start to be a concern.

Source: FDIC/WGA LLC

Likewise, market volatility in March was extraordinary after the twin failures of Silicon Valley Bank and Signature Bank. The VIX traded over 25 for the first time since October 2022 and for most of the month. Q3 2022 was the start of the present rally in 10s and out for the Treasury curve. Volatility fell back below peak levels by the end of the month, but it is fair to say that modeling these markets remains a challenge.

How the largest banks manage their asset-liability risk is one of the more important aspects of earnings in 2023. Look for duration smart results from JPM and USB, among the larger banks, and Mr. Cooper (COOP) and, Rithm Capital (RITM), the REITs in 1-4s. Of note, significant personnel changes at PennyMac Financial (PFSI) have caused this once leading MBS issuer to step back in terms of pricing in conventional loans.

JPM managed to shrink assets in Q4 2022, but loan growth was also low and well-below the 14% growth reported for Peer Group 1. JPM actually shed non-core funding in Q4 even as banks generally saw a massive uptick in the usage of non-core funding in Q4 2022. Was this the clue that the data dependent Fed missed? We think so. The fact that Peer Group 1 averaged a 98% change in the usage of hot money is the proverbial dog that did not bark in the night.

NY Fed President John Williams says that he sees no sign of credit tightening, yet the bank data gathered by the Fed suggests otherwise. Net credit losses as a percentage of average assets have been climbing for a year, as shown in the chart below.

Source: FFIEC

Note that Citi with its subprime consumer lending book has a loss rate 5x Peer Group 1, which is the dark blue line running along the bottom of the chart. Because of the higher credit spread, Citi is a leading indicator. Next below Citi is USB, which also tends to track above the other money center banks in terms of loss rates. Then comes JPM in the middle of the pack. BAC and then WFC have lower loss rates but also inferior operating performance, as we discuss below.

The Street has JPM growing revenue by high single digits in Q1 2023, but it is important to recall that the bank’s pretax income was down more than 20% in 2022. The comparison with 2021 was muddied by the favorable GAAP adjustments to income in that year after the huge and unnecessary provisions put aside in 2020.

Even if JPM hits the Street’s growth numbers, the bank will still be way behind compared to 2021. A big reason for the difficulty that JPM and other large banks will have in growing revenues has to do with the yield on the loan book, which is only starting to recover from QE.

Source: FFIEC

Observe that Citi also leads the group in terms of gross yield because of the subprime consumer portfolio. Next is JPM at just shy of 5% followed by the average for Peer Group 1. The rest of the group is still showing yields below peer and just barely above 4% before funding costs and SG&A.

Given that the US Treasury is paying 4% for 90-day T-bills, you can see how far banks have to go in terms of asset returns to become competitive. To get another perspective on banks and QE, the chart below shows the return on earning assets (ROEA) as calculated by the FFIEC.

Source: FFIEC

That the average for Peer Group 1 leads the pack reflects the diverse results of the 132 banks represented in the average. Smaller banks tend to get better pricing on loans than do the larger banks. Context matters, however. Today Peer Group 1 is still a point below the ROEA at the end of 2019. Notice that JPM and BAC are last among the top five banks, illustrating the huge, underperforming securities portfolios of these giants.

USB, on the other hand, is competing with Citi for the leadership of the group even though it has a far lower gross spread on its loans. USB managed to grow assets and loans in 2022, albeit because in December it closed the acquisition of MUFG Union Bank's core retail banking operations. Unlike the other larger banks among the top-five depositories, USB is still able to pursue acquisitions.

The Street has a lower revenue growth estimate for USB for 2023, but we expect that the Minneapolis-based bank will continue to perform above peer. The chart below shows the efficiency ratios (Overhead expenses/Net Interest Income + non-interest income) for our group and Peer Group 1.

Source: FFIEC

Peer Group 1 and JPM have the best (lowest) efficiency ratios, which you can think about as the dollar cost of revenue. USB is next, followed by BAC, Citi and WFC, which is in distressed territory above 75% efficiency. A combination of down-sizing and expenses related to remediating various regulatory problems has made WFC well-nigh distressed in recent years. Until WFC management gets that efficiency ratio down into the 60s and keeps it there, we would not take them seriously. Operating efficiency is a simple but effective proxy for the effectiveness of management.

Despite the bank’s miserable performance, the Street still manages to be constructive on WFC, showing revenue growth that is seemingly in conflict with recent results. Assets fell 3.5% at WFC in 2022 while loans grew 5%, a remarkable achievement given that WFC exited correspondent lending in 1-4s last year. Only half of WFC’s $1.8 trillion balance sheet is invested in loans, yet the bank managed to keep its mark-to-market losses to less than 10% of capital in Q4 2022.

Incredibly, the Street analysts are less constructive on BAC than on Wells Fargo. BAC dropped assets by single digits in Q4 and was below peer in terms of loan growth, two metrics that will not surprise readers of The Institutional Risk Analyst. BAC’s net loss rate is pedestrian, illustrating more the bank’s remarkable torpor more than a deliberate risk management choice, yet losses are rising.

Historically, BAC made its earnings by keeping credit losses and funding costs down. But now interest expense is rising faster at BAC than either JPM or USB. We expect further increases in Q1 2023, even if the bank benefits from the flight to big depositories. Seeing BAC right behind JPM in terms of funding costs in Q4 makes us wonder how much different Q1 2023 will look.

Source: FFIEC

The fact that Citi had an overall funding cost 2x JPM and BAC at the end of 2022 is no surprise since the bank’s net non core funding dependence was over 40% vs 8% on average for other large banks. Despite the double-digit yields on its loan book, the high funding costs at C still result in a lower return on earning assets compared with the other top five depositories. On a risk-adjusted basis, the equity returns from Citi are arguably far lower than say JPM or USB. Maybe that is why the stock is trading 0.4x book.

The Street has Citi growing earnings to $7 in 2023 but only $5.8 in 2024? Revenue growth is in low single digits. Given our view that credit is the next course awaiting many banks, Citi bears close attention because of its subprime credit book. In an environment of rising credit costs, Citi’s profile will not look very attractive. Even if commercial real estate exposures are among the worst pockets of risk in the banking world in 2023, banks with consumer facing exposures are likely to be punished further.

The bottom line for earnings is shown in the relationship between net income and average assets. The first thing to notice is that the smaller banks are performing far better than their larger peers. This situation is likely to reverse in Q1 2023, however, as smaller banks are forced to drop loan rates and raise deposit rates in order to retain business.

Source: FFIEC

The good news for all banks is that the huge unrealized losses that caused the failure of Silicon Valley Bank will continue to moderate in Q1 2023. So long as the 10-year Treasury is closer to 3% than to 4% yield, the ugly disclosure of mark-to-market losses will be manageable for most banks. Capital markets activity is unlikely to rebound significantly as LT rates fall, but reduced volatility may help large bank results later in 2023.

The bad news is that without active sales of securities from the SOMA, bank asset returns are unlikely to return to pre-COVID levels. As credit expenses rise in Q1 2023 and the balance of the year, banks are likely to see operating income squeezed between higher funding costs and sluggish yields on earning assets. At the end of the day, the spread between operating income and provisions for credit losses is the most important relationship in banking. The Fed's gift to banks in Q1 2023 is dismal capital markets results and constrained asset returns. The asymmetry of Fed interest rate policy between rate hikes and SOMA asset sales is going to create problems for banks until the imbalance is reversed.

Source: FDIC

The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.