R. Christopher Whalen
Jan 13, 20236 min
January 13, 2023 | Premium Service | Bank earnings kicking off Friday the 13th of January seems a little less than auspicious, but prices are rising even as earnings soften. JPMorganChase (JPM) closed yesterday a bit north of 1.7x nominal book, but what is the real book value ex-Fed of the large banks? Nobody seems to care about tangible value much less about premium valuations in the world of institutional equities.
We are scheduled on CNBC Worldwide Exchange 5:30 ET Tuesday January 17th to talk bank earnings with Brian Sullivan.
To understand the valuation of bank stocks as year one of quantitative tightening approaches, discard any concern about bank fundamentals and instead ponder the wants and needs of Buy Side advisors. Assets under management have been taking a beating over the past year, thus banks are both a shelter from the storm and a potential source of alpha, yet very expensive.
Tom McClellan noted recently that if the stock market in 2023 was going to continue following the pattern from 2008, “then we should be seeing a sharp decline right now.” Yep. Instead, he notes, “the stock market is showing nice strength in January 2023.” Especially with LT interest rates falling.
One of the sectors that has been most resilient to the ill-effects of the Fed’s interest rate hikes has been financials, which have rallied as long-term rates have fallen. Falling rates are good for financials, rising rates are bad, thus as the Treasury yield curve has rallied bank stocks have risen. Remember, rising LT rates and widening spreads are bad for book value.
JP Morgan Chase
JPM managed to reduce accumulated other comprehensive income (AOCI) to just negative $17 billion, a reduction in less than $2 billion attributable to the bond market rally in Q4. JPM likewise is anticipating falling market rates overall, even as the FOMC continues to raise interest rates by more modest increments. The chart below shows AOCI and JPM’s capital structure.
JPM CFO Jeremy Barnum cautioned investors about the timing, magnitude and direction of interest rates and guided investors to negative net interest income growth for the year due to “rising interest rates.” Of note, in Q4 JPM saw interest expense soar 59% sequentially with the YOY comparison showing almost 7x increase in funding costs, as shown in the table below from JPM's earnings release.
JP Morgan | Q4 2022
Barnum focused his presentation on the wide dispersion in possible outcomes for funding costs, causing several analysts to ask follow up questions on the JPM call. CEO Jamie Dimon said he did not want to give investors a false sense of certainty as to the interest rate outlook. But Dimon put down a bullish marker for the year, saying that JPM would earn high teens ROTCE in a mild recession. But will the regulators move the goalposts on bank capital again?
The same volatility that we have observed in the business models of other money centers such as U.S. Bancorp (USB) is clearly visible with JPM. As funding costs rise and the mix of interest-bearing vs non-interest-bearing deposits. Non-interest-bearing deposits were down almost 10% YOY, but total deposits were down 5% YOY. “We expect tough competition going forward,” Dimon advised.
JPM continues to perform better than the other top-four banks and have even achieved its targets for regulatory capital one quarter early, in theory allowing for resumption of share repurchases. But further changes to the bank’s regulatory capital and liquidity requirements loom in the future, one risk that Dimon and his team cannot quantify.
"We have never had zero rates, never had rates move up this fast," Dimon said on the investor call today. We suspect that the uncertainty cause by rapidly rising interest rates is also driving regulatory concerns about capital, even as credit costs remain at 80% of pre-COVID levels.
Source: FDIC
Wells Fargo & Co
The cautious tone for bank earnings was set when Wells Fargo & Co (WFC) suddenly announced that it would be accelerating its withdrawal from the market for 1-4 family loans. This is a dismal development for the housing market and another example of over-reach by the Consumer Financial Protection Board.
A reader of mortgage maven Rob Chrisman noted earlier this week that “Wells stepped up in 2009, 2010, 2011. At that time BofA, Citi and GMAC all shut down correspondent production. Others slowed production, like SunTrust, BB&T. Chase raised standards to slow production. Not Wells.” Ditto.
Large banks have come and gone from residential mortgages. WFC actually exited mortgages in the early 1990s, but the volumes of bull market residential lending pulled them back into the game. Now there are no large banks involved in correspondent lending, a tragic outcome to progressive excesses in Washington.
Of note, WFC reported a 23% drop in the fair-value of its mortgage servicing rights, this in an industry where MSR values are rising rapidly but are not yet near record levels, a shown in the chart below.
Source: FDIC
The multi-billion dollar fine the CFPB levied against the bank likely prompted WFC's board to immediately stop correspondent purchases of loans from smaller lenders. Correspondent production at Wells Fargo accounted for $9.1 billion of the bank's $21.5 billion total mortgage volume for the third quarter of 2022.
Given the above, in Q4 2022, the bank’s results were awful. Asset and equity returns are at the bottom of Peer Group 1. Net income was down 40% YOY driven by higher credit expenses and operating expenses, as shown in the table below.
Wells Fargo & Co | Q4 2022
Interest expense for WFC was up 400% YOY and 82% sequentially from Q3 2022, a stark illustration of the balance sheet volatility caused by quantitative easing. Interest income, by comparison, was up “only” 76% YOY and 23% sequentially, illustrating the revenue squeeze facing some of the largest banks.
Wells Fargo & Co | Q4 2022
Although WFC has shown some signs of life in the equity markets, these latest results as well as the impending withdrawal from correspondent lending in residential mortgages are a negative for the enterprise. We look for further shrinkage in the WFC business and balance sheet, including bulk sales of all Ginnie Mae MSRs and the loss of related escrow deposits.
Bottom line: We expect bank stocks to continue rising so long as medium and longer-term Treasury yields fall. Rising interest rates are bad for bank book value, asset values and therefore credit. WFC’s AOCI in Q4 2022 was down 7% sequentially, roughly tracking the improvement at JPM. But both the managers of JPM and WFC are cautioning investors to temper their expectations for future earnings.
Our latest disclosures are below. SWCH is gone and we sold our CMBS position, added to our LT Nvidia (NVDA) position and picked up some Credit Suisse (CS) on the lows (h/t Alan B). We note that our flutter in Loan Depot (LDI) has been good for almost a 100% gain as mortgage rates have fallen. But nothing lasts forever in mortgage land or in financials. Stay tuned and pay attention to LT rates and spreads.
L: CS, CVX, NVDA, WMB, JPM.PRK, BAC.PRA, USB.PRM, WFC.PRZ, WFC.PRQ, CPRN, WPL.CF, NOVC, LDI
So long as credit spreads continue to tighten and long-term rates are falling, banks are likely to benefit. But any sign that credit costs are rising above pre-COVID levels will be a show-stopper as far as public equity valuations are concerned. Meanwhile, as ST interest rates normalize, banks will be battling to earn higher asset returns in a shrinking market, one reason why Jamie Dimon knows that he still has gobs of excess capital in his business given a smaller balance sheet.
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