Top-Five Banks: Q1 '24 Earnings Setup

March 20, 2024 | Premium Service | First, let’s start with some happy thoughts. Over the past year, the WGA Bank Top 25 Index is up 39.7% vs 28.8% for KBWB. Because there are only three stocks that overlap the two groups, it is possible for KBWB to outperform the WGA Bank Top 25 Index, as it did over the past two months. This dichotomy is a product of market volatility and size. It also illustrates why a long/short strategy is required with financials. Of note, the WGA Bank Top 10 Index continues to outperform the larger KBWB.

In our last issue, we talked about the latest developments at New York Community Bank (NYCB). After our comment was posted, Raymond James (RJF) analyst Steve Moss downgraded NYCB from its earlier rating of market perform and set a fair value estimate of $3 a share. Later, an official of NYCB accused us of “wild speculation.” We stand by our comment, but we'd be delighted to be wrong.

Needless to say, after receiving that vote of confidence from NYCB, we sold the rest of our position in the stock. This is not IndyMac in 2008, ladies and gentlemen. That bank was closed in July 2008 and cleansed in an FDIC receivership before being sold nine months later to a group of investors led by former Treasury Secretary Steven Mnuchin. 

On March 19, 2009, the Federal Deposit Insurance Corporation completed the sale of newly chartered IndyMac Federal Bank, FSB, to OneWest Bank.  The deal occurred because the Federal Open Market Committee had begun cutting interest rates months before. The FDIC led by Chairman Sheila Bair also put loss-sharing on the table. The proverbial investor crowd filled the empty room. But, of note, OneWest was the first and last investor sponsored bank sale by the FDIC post 2008. 

Based upon last week’s 10-K from NYCB, we don’t see how the bank’s situation will be resolved short of an FDIC receivership and sale a la IndyMac. Where did we put the proceeds of the sale of NYCB shares? Into U.S. Bancorp (USB). Along with Wells Fargo (WFC), USB is one of the most improved members of the top-five banks. Below we discuss some of the largest banks measured by assets to set up our readers for Q1 2024 earnings.

The Q4 2023 earnings results and the just-released bank holding company performance reports from the Fed illustrate the sharp drop in earnings experienced by banks. Looking at Q1 2024, the issues for investors include rising loan loss provisions, again, led by commercial real estate, credit cards and auto loans. The rate of increase in provisions, combined with relatively flat net income on earning assets, could mean another equally disappointing quarter awaits. But not nearly as horrible as Q4 2023.

First we look at credit losses at the top-five commercial banks by assets. The increase is steady and accelerating. A number of banks have seen net credit losses double year-over-year, thus the question is whether the negative trend will continue to accelerate. Our best guess is that defaults and related provisions for loss will continue to grow.

Notice that the average net loss rate for Peer Group 1 is at the bottom of the chart, while Citigroup (C) with its subprime consumer loan book is already at 1% net loss.  That may sound like a lot relative to other large banks, but there are many other, smaller banks with significantly higher loss rates and gross loan spreads than Citi.  CapitalOne (COF), for example, was at 2.5% net loss in Q4.

Source: FFIEC

Of interest, the net loss rate for Goldman Sachs (GS) was right behind Citi in Q4, this even though GS has sold the ill-fated Marcus consumer banking business. This is remarkable because among the large “asset gatherers,” which tend to have very low credit expenses, GS is an order of magnitude above the other banks in terms of net credit losses.

Why is GS losing so much money on credit? GS, for example, has 10x the loss rate of Morgan Stanley (MS). Notice in the chart below that the loss rate for Peer Group 1 is higher than MS and most of the other universal banks. Notice too the idiosyncratic nature of the loss results, a quality somewhat shared by Raymond James. Notice that Charles Schwab (SCHW), Morgan Stanley and Stifel Financial (SF) are crawling along the bottom of the chart at near-zero net credit loss.

Source: FFIEC

After loss rates, the next area of inquiry is gross spreads on loans and leases. The ability of banks to increase the yield on earning assets like loans and securities is directly connected to growth in net income. The banking industry has seen net-interest margin move sideways for the past two years because funding costs have risen faster than asset returns. 

We expect to see this trend of NIM compression continue. With higher credit costs, we may see another weak quarter for net income, but w/o an FDIC assessment and other one-time expenses. Notice that of the top five banks, Citi is the only name that is adding significantly to gross loan yield. This is why Citi was able to improve its position to 56th in the WGA Top Bank 100 in Q1, even though its net income was down sharply. 

Source: FFIEC

Given that market interest rates have rallied more than a point since Q4, it is unlikely that banks are going to see additional margin expansion in Q1 2024. The flood of private credit funds pouring into the market in search of gain in performing or non-performing assets has put additional downward pressure on yields. The competition for large assets by banks and various nonbank players is intensifying. Even as the demand for assets by banks and nonbanks grow, funding costs continue to rise, as shown in the chart below.

Source: FFIEC

Notice in the chart above that C actually managed to reduce its funding costs in Q4, yet another indicator of the efforts by CEO Jane Fraser to improve the bank’s performance. Meanwhile the rest of the group is still seeing higher interest expense compared with average assets. WFC has the lowest cost funding, while Bank of America (BAC) is second only to Citi in terms of funding costs – an ominous sign. 

Once we consider funding costs, the last two relationships to ponder are net income and overall asset returns, essentially two perspectives on the same relationships. The first chart shows the group in terms of net income vs average assets. All of the banks in the top five saw net income fall, not just in Q4 but for most of 2023. We expect to see improved results in Q1 2024, but improvement may simply mean moving sideways from the Q3 2023 baseline. 

Source: FFIEC

The next perspective after net income is to see how the bank is doing in terms of returns on earning assets (ROEA).  This is one of the key relationships for assessing the long-term profitability of any bank but focuses on the interest revenue of the bank. So while JPM is the top performer in the chart above, JPM has the second lowest ROEA in the chart below. BAC is at the bottom of the group because of the bank's poor asset returns.

Source: FFIEC

So how can JPM be the top-performing large bank in the US with one of the lowest ROEA in the group? Because only half of JPM's $3.8 trillion balance sheet is banking and the non-interest income from advisory and capital markets provides superior returns overall.

JPM just declared a quarterly dividend of $1.15 per share, an increase from the prior quarterly dividend of $1.05 per share. We view this as a sign of strength from JPM. But as we noted in The IRA Bank Book for Q1 2024, the dividend flow from the industry may be constrained in 2024.  In order for publicly listed bank holding companies to pay dividends to public shareholders, they must receive dividends from the subsidiary banks.

Source: FDIC

Bottom line: We see higher credit costs, narrowing NIM and still rising funding costs squeezing the banking industry in Q1 2024. The rally in market interest rates since Q4 has already compressed bank loan yields, making arguments for interest rate reductions less than convincing. With the prospects for any action by the FOMC on lowering short-term interest rates being pushed into next year, we see the first likely move by the Fed as slowing the rate of runoff of the balance sheet. It may be a very long year.

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