Updated: Jul 16, 2021
June 23, 2021 | In this edition of The Institutional Risk Analyst, we update our readers on the top-five commercial bank holding companies (BHCs): JPMorgan (NYSE:JPM), Citigroup (NYSE:C), Bank of America (NYSE:BAC), Wells Fargo & Co (NYSE:WFC) and U.S. Bancorp (NYSE:WFC). We share this example of the Premium Service of The Institutional Risk Analyst with all of our readers.
BNN-Bloomberg: U.S. banks looking
to get smaller post COVID-19
Of note, USB has now dropped to the number eight position, supplanted by Charles Schwab (NYSE:SCHW) at $580 billion in total assets and more than $350 billion in core deposits. The good news is that Q1 2021 earnings for the large bank group were much improved, but the bad news is that much of that income was earned a year ago. The table below shows the top 13 BHCs by total assets.
The first key indicator we look at is income, where all of the top five commercial banks have seen significant improvements. One consistent factor present in all of the results was the release of loan loss provisions (LLPs) back into income, which essentially means that credit reserves put aside in 2020 are now migrating back into income in 2021. Once this release of LLPs is finished, however, the run rate revenue and income for the group is likely to decline.
The Street has JPM earnings rising from $8.80 in 2020 to $11 at the low end of the estimates for 2021, but on declining revenue. The sequential comparisons in the charts above are obviously quite skewed, but an inspection of the 2019-Q1 2020 results illustrated above gives you a better sense of the run rate going forward, excluding the one-time release of LLPs. Of note, all of these names hit 12-month highs at the end of Q1, but JPM and Citi have since given ground.
There was a relatively late rush by institutional managers into BAC and WFC early in 2021, largely due to the fact that these relative underperformers were cheap. Now they are not so cheap, but they are still underperformers as shown in the first chart showing net income vs average assets. Sadly, most professional equity managers cannot even discuss the business model difference between the top five US depositories.
There is always a contrarian element in the world of institutional money managers that believes that WFC and BAC, two badly managed banks, will somehow spring back to life. We politely disagree with such uninformed views. USB and JPM are the best performers in the group financially and operationally, and in our view, are still the best value, albeit quite expensive due to the effects of the FOMC’s quantitative easing. Notice how little volatility in book value multiples occurred with JPM and USB vs the rest of the group. The chart below shows the gross spread on total loans and leases for the top-five BHCs.
Notice also that the gross spread on loans and leases for the entire group is falling even as earnings surged in Q1 2021. Indeed, BAC and WFC are the worst performers in the top-five and are actually tracking well-below the average for Peer Group 1, which includes the top 125 banks in the US above $10 billion in total assets. The subprime portfolio of Citi generates the biggest spread, but C only manages to hit peer net income levels once credit expenses and operating costs are subtracted.
With the evolving situation regarding interest rates and FOMC policy, there will not doubt be an expectation among veteran investment managers that bank earnings will be helped. This is not always the case, however, because banks make money on spreads not interest rates. Spreads on loans and securities remain under pressure as Q2 2021 draws to a close, thus caution is recommended before concluding that banks will see expansion of loan spreads and thus earnings in 2021.
The chart below shows net loss rates for the group vs average assets, again illustrating that the relatively benign credit environment is the biggest driver of bank earnings at present. Notice that BAC’s loss rate is elevated compared with the other banks and especially Peer Group 1. Since BAC’s income is tracking below the peer average, the net results are not particularly impressive.
Notice also the nose-bleed levels of loss being generated by the subprime loan book of Citi, a bit over 1% net charge-offs vs less than 40bp for the other four banks and less than 20bp for all of Peer Group 1. Even though Citi makes a lot of money on its assets, the credit costs and operating expenses still result in a mediocre outcome overall. Outside of Citi, the highest loss rate of the top five BHCs is JPM, but CEO Jamie Dimon makes more money per dollar of assets.
Finally, we look at funding costs, the chief benefit to banks from the FOMC’s quantitative easing program. Funding costs are at historic low levels, as shown in the chart below. But low funding costs does not help offset shrinking spreads.
Of interest, the lowest funding costs in the group were found at JPM, at 16bps vs average assets. Next behind JPM is BAC at 18bp through Q1 2021, but the poor asset returns and operational efficiency of BAC delivers poor results overall.
The Bottom Line
The earnings of the top-five banks in Q2 2021 are likely to hit the same levels seen in Q1 2021 due to the release of credit reserves from last year, but we believe that results in 2H 2021 are likely to fall to the actual run-rate for revenue and income at current levels of business volumes. Most of the larger U.S. banks are tracking toward lower levels of revenue in 2H 2021, creating some significant challenges for investors that have crowded into some very expensive stocks.
Source: Google Finance
Our exposure to the equity of financials is limited to a stake in Annaly (NYSE:NLY) that we began accumulating last summer at 0.5x book and some bank preferred stocks. The current level of valuations for large US banks are simply not attractive for us and reflect a disconnect between fundamentals and market prices that is largely a function of the actions of the FOMC.
So long as the FOMC continues with QE, we expect that bank equity valuations will remain elevated, but the gap between earnings and revenue, and equity market valuations, may continue to grow. In the meantime, look for that same group of institutional money managers that were pounding the table for Wells Fargo and the Bank of America in Q1 to push bank stocks higher between now and the end of Q2 2021.
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