Bank Earnings & Financial Repression | 70

April 4, 2018 | Why are financials selling off as earnings season starts next week? Large cap banks such as JPMorgan (NYSE:JPM) led the markets higher earlier in the year, but have since underperformed the markets. What gives?

First and foremost, when the markets are looking for a reason to sell, large cap financial names usually catch more that their share of attention. Remember that Wall Street only ever cares about the top 10-names in financials by market cap.

When the thundering herd sells, banks usually get a disproportionate share of the short volume. The sector accounts for about 15% of the S&P 500. When a broad selloff is underway, look for financials to participate and then some, both in terms of cash and the highly liquid derivatives.

Second, financials are overvalued – still. When JPM peaked at just shy of $120 per share on February 26th of this year, the market leader was trading just shy of 2x book value. The stock is still up 15% over the past six months vs single digits for the S&P 500. JPM has single digit equity returns and no real growth in terms of revenue. Hit the bid.

Third and most important is the question of net interest margins and financial repression. In the inaugural edition of The IRA Bank Book, we discuss why the banking industry is facing a squeeze on margins thanks to the Federal Open Market Committee. Few analysts on the Street know or care about this looming threat to bank profits.

At present, the US banking industry is earning about $130 billion per quarter in net interest income from loans and investments, but is paying depositors and bond holders a mere $20 billion per quarter for funding. This skew in favor of bank equity holders has been extreme since 2008, but the issue of financial repression goes back to the 1990s. Ponder the chart below.

Source: FDIC

In Q4 2007, when US banks grossed $180 billion from loans and other earning assets, they paid depositors and bond investors almost $100 billion. In 2015, the total cost of funds for the US banking industry was just $11 billion per quarter, but the industry booked $110 billion in net interest income. Get the joke?? Bank depositors and bond holders should be earning more like $40-50 billion per quarter.

Today yields on deposits and fixed income securities are rising faster than the yields on bank loans. Just as the FOMC suppressed the cost of credit for banks after 2008, now the financial engineering of former Fed Chair Janet Yellen has created an interest rate trap for banks a la the 1980s.

For those of you who missed that party, in the 1980s funding costs for S&Ls rose faster than asset earnings, gutting the capital of the entire housing finance sector. The unfortunate demise of the S&Ls also created the opportunity for banks to get into mortgage lending a decade later with similarly disastrous results.

We look for the cost of bank funding to rise faster than the yield on earning assets over the next two years, a situation that is likely to put an effective cap on bank earnings and public market valuations. The kicker in the analysis is that credit costs are also likely to rise faster than either revenue or pre-tax earnings, adding an additional headwind to financials as 2018 unfolds.

See you on CNBC Squawk Box tomorrow ~ 8:00 ET.

The Institutional Risk Analyst (ISSN 2692-1812) 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.