GSE Release? Really. What Do JPM and BAC Say About 2025 Earnings?

January 16, 2025 | Premium Service | In this issue of The Institution Risk Analyst, we look at the good and the bad in Q4 2024 bank earnings from two of the largest US banks. But first we wanted to share an observation about the prospect of releasing the GSEs, Fannie Mae and Freddie Mac, from conservatorship. 

Earlier this week, Mark Zandi of Moody’s Analytics and Jim Parrott of Urban Institute, nicely laid out the case against releasing the GSEs without new legislation (“Fannie and Freddie’s Implicit Guarantee: Another Iceberg on the Path to Privatization”). The key paragraph in the piece is below:

“In its recent note on how it would rate the GSEs if released from conservatorship, Fitch discusses the impact of the level of government support assumed. It states that it would likely continue to align the GSEs’ rating with that of the government, but partly because Fitch assumes the GSEs would retain a 'dominant market presence.' We take this to mean that Fitch is assuming that the government would remain committed to bailing out the GSEs if they failed—that they have an implicit guarantee. We believe that other ratings agencies would also continue to align the ratings of the GSEs with that of the government if they assumed an implicit guarantee. But we believe that they would downgrade the GSEs meaningfully if convinced that they were being released without the implicit guarantee.”

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In simple terms, if and when the GSEs exit conservatorship w/o legislation from Congress, the conventional secondary loan market is basically kaput. Loans guaranteed by Fannie Mae and Freddie Mac will no longer be “risk free” assets, which means that the options for financing conventional loans will dwindle.

For example, conventional loans will no longer be “eligible for pooling” for the purposes of term REPO and bank warehouse lines. Conventional loans will no longer be eligible for the to-be-announced (TBA) market and they will effectively become private label loans. Hedging interest rate risk related to conventional loans will become more costly and, in many cases, problematic outside of bank warehouse financing. Sound like a disaster? Yup.

The conventional market will divided into a bank market for larger, above average (~$400k) loans and below-average loans, which will migrate back to FHA/VA/USDA and Ginnie Mae. In a release "as is" scenario, it is easy to see secondary market spreads rising at least 1% in the event, meaning that the cost to consumers for a conventional loan will rise by at least that amount.

A senior member of the ratings community summed things up after reading the Zandi/Parrott analysis: “I thought they would have come out even stronger re: MBS. MBS have to be viewed as risk free otherwise exit from conservatorship does not work in all markets, not just stressed markets.”

The same well-placed observer notes that an equity raise for the Treasury upon release is a really bad idea and, in fact, will be really hard to achieve w/o weakening the credit standing of the GSEs. As we’ve noted and he adds, we don’t know what the profitability of Fannie and Freddie will be as we do not know where MBS and unsecured debt will trade post-release.

We continue to believe that the odds of actual release from conservatorship for the GSEs remains 1:5 or less. The reason is very simple. Most investors in conventional MBS cannot conceive of a world in which the bonds are not risk free assets. It does not compute. Once a large enough crowd of people comes to appreciate the realities of releasing the GSEs "as is," the proposal will become politically toxic and the various trades and financial institutions will oppose it.

If we actually convince a large number of global bond investors that President Donald Trump is reckless enough to crater the $7 trillion conventional loan market to he can force another tax cut through Congress in 2025, then the selloff in MBS and also Fannie and Freddie unsecured exposures will be massive. The collapse of the conventional loan market may even lead to a larger selloff in the US markets. There, we said it.

What Do BAC and JPM Say About Bank Earnings ?

In the Q4 2024 earnings supplement for Bank of America (BAC), if you turn to Page 9, “Quarterly Average Balances and Interest Rates,” you may peruse the asset returns and funding costs in the table. Then look at the bottom of the table and notice that the net interest spread was unchanged YOY. This summarizes the position of the US banking industry as 2024 ended with average asset returns still below 1%.

But for the strong results in terms of equity and debt capital markets, BAC and most other banks would have reported down quarters. The one exception is JPMorgan (JPM), which increased earnings and asset returns in Q4 2024 and the full year. JPM pushed asset returns up to 1.35% while maintaining operating efficiency at 53%, yet the bank noted compression in deposit margins. JPM does not disclose net interest margin in its earnings materials.

JPMorgan | Q4 2024

BAC managed to reduce the rate paid on deposits below 2% and grew topline revenue 15% YOY. This all looks great from a distance, but BAC still only managed to deliver 0.8% return on assets or well-below the average of ~ 0.9% for Peer Group 1 in Q4. Interest income rose 12.3% YOY, but interest expense rose 23% or almost twice as fast. Likewise, JPM saw interest income rise 14% but interest expense rose 25%. NIM at BAC was down slightly vs 2023 and funding costs overall rose significantly, as shown in the table below.

Bank of America | Q4 2024

If we review the income statement for BAC, commissions and profits from capital markets figure prominently. Again, if we back out these extraordinary items from earnings, BAC would have reported a down quarter due to higher funding costs and operating expenses. The source of these gains was interest rate volatility in the second half of 2024, a market environment that may not be repeated in 2025. The summary income statement for BAC from the Q4 2024 supplement is below.

Bank of America | Q4 2024

As you can see, if we back out the big increase in fees and commissions and market making activities, BAC would have reported down earnings due to flat NIM and rising funding costs and SG&A. Notice also that other income (loss) was $3.4 billion, which in Q3 included "certain negative valuation adjustments, partially offset by lower losses on sales of available-for-sale debt securities."

Most banks which have reported so far have featured a build in terms of loan loss reserves, adding further evidence that 2025 could be the year when credit becomes a key factor in bank earnings. But perhaps the biggest surprise from BAC and other large banks that have reported so far this week is the modest growth in deposits.

Both JPM and BAC had negative deposit growth in Q4, suggesting that these banks are choosing to run off assets given the rising cost of funds. Deposit runoff at JPM and BAC suggests that loan growth could likewise be flat or even negative across the industry in 2025. Unless the FOMC relents and begins to again increase the size of the central bank's balance sheet, we may see shrinkage in bank deposits in Q1 2025, a scenario that few analysts are anticipating.

May 2025

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