R. Christopher Whalen
Mar 25, 20217 min
March 25, 2021 | In this edition of the premium service of The Institutional Risk Analyst, we set up bank earnings for Q1 2021. Despite all of the heavy breathing coming from the endless parade of constructive Buy Side managers on financial media, bank equity market valuations are still lower today than the levels seen this time last year, as shown in the chart below.
Source: Yahoo
Part of the reason for this irrational exuberance from Buy Side managers is that there are not a lot of alternatives to large cap financials. Just as American consumers are faced with an increasing scarcity of housing assets, investment managers are left to pick among the leftovers in the world of value-based equity finance. Large banks may be big in terms of market capitalization, but are equally constrained in terms of forward earnings potential.
As we noted in the most recent edition of The IRA Bank Book, Q1 2021 will be a good quarter for bank earnings because of the prospect of significant loan loss reserve releases back into income. Take JPMorgan (NYSE:JPM), for example, which had $28 billion in loan loss reserves at the end of 2020 vs $13 billion at the end of 2019. Half of this amount could arguably be released into income during 2021.
The timing and magnitude of the loss reserve releases, of course, will depend crucially upon the preferences of regulators and auditors. With charge-offs unchanged from the previous four quarters, we estimate that the Federal Reserve Board and other prudential regulations will slowly allow JPM to recapture billions per quarter during 2021 – at least as long as credit loss rates remain muted. The chart below shows net charge-off rates for the top five US commercial banks as a percentage of average assets.
Source: FFIEC
As you can see, net loss rates have risen for U.S. Bancorp (NYSE:USB) while the rest of the group and Peer Group 1 have declined since Q2 2020. We have learned over the years that USB marches to its own drummer when it comes to the timing of loss recognition, suggesting to us that the bank may have been cleaning house ahead of further COVID credit losses this year. When you have strong capital and income, you have the luxury of being proactive on credit. But as you can see in the chart below, USB is suffering compression on gross loan spreads just like the rest of the industry.
Notice too that Citigroup (NYSE:C) actually saw loss rates decline in Q4 2020, this from the most subprime consumer portfolio in the top ten. Citi routinely has over 100 basis points of net default from its subprime credit card and unsecured consumer portfolios, which have a gross spread in the mid-teens. Most of Citi’s asset peers, by comparison, have credit card portfolios with a gross spread of 500bp or one third of the gross spread of Citi. Totally different businesses. Indeed, Citi looks more like a finance company than a commercial bank, a legacy of acquisitions long ago.
Source: FFIEC
Despite the strong downward pressure on asset returns, the top five banks are still managing to report modest earnings, though again far below the levels of a year ago. A big part of helping banks maintain some degree of profitability was falling funding costs, which are now down to an average of just 41bp for all of Peer Group 1. Note in the chart below that Bank of America (NYSE:BAC) has the lowest cost of funds of the group but also has some of the worst asset returns, resulting in an overall mediocre performance.
Source: FFIEC
The net, net of falling funding costs, weak loan growth and soft pricing for large commercial and industrial (C&I) loans is weak income. US banks are running at income levels that are less than half of a year ago. The reserves being released back into earnings were earned a year or more back, thus the prospective visibility on future earnings is not very good. The chart below shows the earnings for the top five commercial banks through year-end 2020 as a percentage of average assets.
Source: FFIEC
Looking at the group, both BAC and Wells Fargo & Co (NYSE:WFC) are trailing the average for Peer Group 1, which is dominated by smaller, better performing banks. Smaller banks tend to have better loan pricing and asset returns than their larger peers. JPM and USB, the traditional exemplars among the top five banks, are running above the Peer Group 1 average.
The weak and idiosyncratic performance of WFC has to do with the continuing management turmoil in the wake of the banks breakdown in internal systems and controls with the fake account scandal. The banking business at WFC remains sound, but the situation in the CSUITE continues to hurt the bank’s bottom line. The past several quarters earnings for WFC have been so bad that you could justify dropping the bank from the top-five for analytical purposes.
The situation at BAC, however, is more serious because it illustrates the culture of mediocrity that has prevailed at the bank for more than a decade under CEO Brian Moynihan. Even after years of restructuring, avoiding risk and killing profitable business lines, Moynihan managed to report a capital loss of $2.4 billion in 2020 related to an accounting restatement. The destruction of shareholder value at BAC is monumental and ongoing.
During the Q4 2020 conference call, BAC noted that consumer loan defaults in credit cards are likely to rise in Q1 2021 and fall thereafter, the result of COVID deferred loans working their way through the system. Other banks are reporting similar observations, suggesting that whatever “wave” of consumer credit defaults related to COVID is now working through the system could be largely complete by Q2 2021.
Earnings Outlook
Looking at bank earnings for Q1 2021, there are two primary considerations for investors. First, quarterly bank dividends are somewhat constrained, as shown in the table below showing year-end 2020 data, yet most banks have maintained payouts to investors.
Source: FFIEC
Citi and BAC have seen significant improvements in dividends declared by the parent bank holding company, while WFC has suffered as a result of managerial and operational issues. But none of the peers of JPM can compete with the magnitude and consistency of the House of Morgan when it comes to returning cash to investors.
Notice that BAC’s balance sheet is 80% of the size of JPM and produces barely more than half the dividend income. The mediocrity of the House of Moynihan is manifest, yet not a soul on the Sell Side says a word about a management change at BAC. This bank is dead money for investors, IOHO, until we see changes in the CSUITE and board of directors of BAC.
The table below shows share repurchases by the top five banks as reported to the FFIEC. Again, JPM is the clear leader in returning cash to investors. Notice that WFC used to be even with JPM in terms of share repurchases, but today is running around half of the House of Morgan. Overall, share repurchase have been more constrained than dividends.
Source: FFIEC
None of our friends and colleagues in the world of equity managers can accept that most of the top-five banks have negative revenue growth rates for 2021, an inconvenient fact in a world that must already justify diminished cash-to-me returns from banks. The Street consensus has revenue for USB down single digits, for example, but earnings up of course.
BAC is shown with a 1% revenue decline in 2021, this after an estimated 7% decline in Q1 2021 according to the Street consensus. Earnings are seen at $1.90 per share in 2021 and, almost magically, rise to $2.50 in 2022. Somehow, some way, Sell Side analysts always manage to contrive estimates for higher revenue in the out years to justify today's stock recommendation.
The Street has the House of Morgan shrinking revenue this year, perhaps as CEO Jamie Dimon also follows through with his threat to shrink assets by driving large deposits out the bank with rising fees. Negative interest rates are a reality in the US as money centers like JPM and WFC start to impose punitive fees on large depositors.
Not only has the Federal Reserve Board ended the special dispensation for banks with respect to capital measured via the simple leverage ratio (SLR), but we expect that the Federal Deposit Insurance Corporation will also end dispensation for banks with respect to deposit insurance premia. Net, net, we expect to see US banks getting smaller in 2021 as they attempt to shed or avoid the FOMC’s creation of bank reserves.
Remember, as money flows out of the Treasury General Account at the Fed with new stimulus spending authorized by Congress, the money becomes a bank deposit, swelling the size of US banks further. For this reason, we remain very bearish about asset returns for US banks as the FOMC continues its massive asset purchases under quantitative easing (QE). We expect returns on earning assets for US banks to fall another 5-10bp over the next four quarters to the lowest levels in half a century.
Source: WGA LLC
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