Bank Earnings Setup: JPM, USB, WFC, BAC & Citi

June 28, 2022 | Premium Service | As we approach the end of the second quarter of 2022, let’s set up the top-five commercial banks for readers of The Institutional Risk Analyst. JPMorgan (JPM), Wells Fargo (WFC), U.S. Bancorp (USB), Citigroup (C) and Bank of America (BAC) remain the largest commercial lenders in the US, but the top ten US banks now include Charles Schwab (SCHW), PNC Financial (PNC) and Truist (TRU).

BNN Bloomberg 06/28/2022

As you can see from the list below, the top US bank holding companies have changed significantly over the past decade, with several large asset managers now among the larger depositories. There are three groups with lots of overlap, including commercial banks, universal banks and advisory businesses.

The big issue facing US banks in Q2 2022 is the collapse of operating earnings after the end of GAAP adjustments to income in 2021. First banks reserved $60 billion for COVID. Then the Fed took $40 billion per quarter in interest earnings out of the US banking system via quantitative easing or QE, pushing the return on earning assets below 3% for large banks vs almost 4.5% in 2019. The chart below shows return on earning assets for the top five commercial banks and Peer Group 1.

Source: FFIEC

In 2021, the banking industry took that $60 billion in loss provisions back into income, further distorting the sequential and YOY comparisons for revenue and earnings. Stocks soared last year on the artificial boost of bank operating income caused by these GAAP adjustments. Notice that Peer Group 1, which includes 134 banks above $10 billion in assets, considerably outperforms the larger banks, followed by USB. JPM has the worst ROEA of the top five for the second quarter in a row, largely due to the grotesque size of the bank’s $3.9 trillion balance sheet.

Accounting adjustments aside, the decline in earnings power inside all US banks is a direct result of the market manipulation of QE implemented by the FOMC, both in terms of inflating the deposit base and reducing asset returns. QE essentially confiscated earnings on Treasury bonds and mortgage-backed securities (MBS) from bank shareholders and transferred the proceeds to the US Treasury. This is what the folks inside the Federal Reserve Board call “stimulus.”

Source: FDIC

Now that the FOMC is moving in the direction of QT, however, the benefit to the Treasury is ending and banks will see asset returns improve as they did in 2017-2019. The key questions in this regard are 1) the magnitude and 2) the duration of the upward move in interest rates.

The longer interest rates are elevated, the more opportunity banks have to repair the damage done to their balance sheets by the successive efforts of the FOMC under Fed Chair Janet Yellen and Chairman Jerome Powell. It is unlikely that banks will recoup interest income back to 2018 levels, which are half again higher than Q1 2022 results as shown in the chart below.

Source: FFIEC

As with the chart above showing asset returns, JPM, Citi and WFC were the laggards in terms of net income vs average assets. USB actually outperformed all of the other banks and also Peer Group 1, in part because of the bank’s refusal to grow above present levels. Even as it digests the acquisition of MUFJ retail branches in the West, USB CEO Andy Cecere sounded a very positive note during a June 14th conference call:

“Our deposit balances are still well above pre-COVID levels. Spend levels are strong. Our credit card spend is up 35% versus pre-COVID, 15% above last year. There is a little bit of a shift from discretionary and non-discretionary spend. And credit is really good. We are not seeing any early indicators of any weaknesses. So there is – if you look at the here and now, it’s very good. But while we all have a base case, I think the range around that base case is pretty wide and we are prepared with those scenarios because of the uncertainty given inflation and the war and COVID and all those things.”

Disclosure | L: EFC, CMBS, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC

We own the USB preferred but are not tempted by the common, much as we like Cesare and his management team. The Street has USB growing revenue 10% in 2022 and 15% in 2023, metrics we find plausible given the bank’s acquisition and overall financial performance through COVID. USB is down just 16% YTD vs -27% for BAC and -26% for JPM. And to remind our readers of one of our favorite asset managers, Raymond James Financial (RJF) is down less than 10% YTD.

After profits, the next place to turn is credit expense, which remains very benign at present despite a lot of predictions about bad times to come. We remain concerned that one of the side effects of QE was to skew credit costs downward, a factor that now seems destined to reverse and to the same degree. As the chart below illustrates, credit costs have fallen along with asset returns, but the former is likely to rebound faster and to a larger degree.

Source: FFIEC

Even the modest swing in credit expense back into positive territory, this after seeing credits to earnings from reversals of loan loss provisions in 2021, has dampened investor enthusiasm for banks. Most of the banks in our surveillance group are down between 10% and 30% so far this year, but none of these are particularly cheap as yet.

The artificially boosted earnings in 2021 were a pretext for sharply higher market valuations, but now that process has been reversed and then some. Analysts are showing basically no revenue growth for JPM in 2022, for example, and then mid-single digits in 2023.

Another factor that comes into play now as a headwind instead of a tailwind is the cost of funding, which still remains near record low levels but is starting to rise with market rates. Interest expenses vs average assets was just 17bp in Q1 2022 compared with 19bp for all of Peer Group 1.

Source: FFIEC

As interest rates slowly rise, the big question facing the industry for the future is when we’ll see spread expansion for loans. Bond spreads have moved significantly in the past 90 days, implying that banks will find greater pricing power in the future. The industry did see some loan growth in Q1, a positive trend driven by the exodus of credits from the bond market.

Actually generating net growth in terms of bank loan portfolios, net of annual redemptions, however, will require higher growth rates. New high yield issuance is running at a quarter of last years levels, good news for yield hungry banks marginalized during QE. Many PE firms are already complaining about tightening loan terms from major banks for leveraged buyouts.

The chart below shows the gross yield on all loans and leases for the top five BHCs, with Citi obviously far about the pack and Peer Group 1 because of the higher default target rate and accompanying loan spread. Notice that in Q1 2022 Citi was already starting to evidence significant lift in terms of gross yield before its asset peers.

Source: FFIEC

BAC continues to track at the bottom of the group in terms of loan pricing, one reason why the bank is competing with WFC for last place among the top five banks in many instances. Next in terms of pricing is USB, then JPM and Peer Group 1. The smaller banks in Peer Group 1 have far better loan margins than larger peers, making the performance of JPM remarkable.

Morgan Stanley (MS), Goldman Sachs (GS), BAC) and WFC hiked their dividends this week after the U.S. banks cleared their annual stress test exercise. JPM and Citi made no change. The increase in dividends is logical because the banks as a group have excess capital and are unable to originate loans sufficient to utilize their deposit base. They might was well return the excess capital to shareholders, either via dividends or share repurchases, but the latter category is likely to be muted compared with 2019 and 2021. The chart below shows share repurchases as reported to the Fed on form Y-9.

Source: FFIEC

One of the most important measures of bank performance is operating efficiency, which is defined as: Overhead expenses / Net Interest Income + Non-Interest Income. The lower the number, the better able the bank is to take revenue down to the income line. No surprise that smaller banks are more efficient than their larger brethren, but note that JPM is below the average for Peer Group 1, a testament to the strong operating rules inside the House of Morgan.

Source: FFIEC

BAC, Citi and WFC are well-above average, a basic indicator that management is not addressing the cost side of the equation. The Street, for example, has BAC growing revenue by single digits in 2022 and 2023, yet listening to CEO Brian Moynihan on the most recent conference call, you might think that BAC was leading the large bank group in terms of financial performance. Part of the reason for the poor performance is the low asset returns already mentioned, which translate into an elevated efficiency ratio. Moynihan bragged in the Q1 2022 earnings call:

“We reported $7.1 billion in net income or $0.80 per diluted share. We grew revenue, we reduced costs, and we delivered our third straight quarter of operating leverage coming out of pandemic. Net interest income grew 13% and is expected to grow significantly from here. We saw a strong loan growth. We grew deposits. We saw a strong investment flows. We made trading profits every day during the quarter. We grew pretax pre-provision income by 8%. We had a return on tangible common equity of 15.5%.”

One of the big ideas of Moynihan in recent months was to swap the bank’s $200 billion Treasury portfolio into floating rate, but BAC will need more aggressive ideas to move the needle on asset and equity returns. The bank’s held-to-maturity residential loan portfolio contains another $500 billion in low-yielding assets. CFO Alastair Borthwick noted recently that $15-20 billion in prepayments come off the book each year, meaning that the low-yielding assets created in 2020-2021 will be with BAC shareholders for years to come.

With WFC, the situation illustrated by the high 70s efficiency ratio is relatively problematic. The bank needs to cut its overhead expenses by about 8-10% in order to get back into line with its peers. The Street analysts have WFC revenue falling by single digits in 2022 as the bank continues to shed businesses. We’d discount any estimates for WFC next year as entirely speculative. This bank has great potential, but WFC is now less than half the size of JPM and is likely to get even smaller in the near future.

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