New York | There are a number of factors that have led to the historic gains seen in equity markets since the election of Donald Trump and the subsequent tax cuts, especially when it comes to financials. Some of these assumptions were never realized, others no longer pertain. Number one was the idea that tax cuts would drive an increase in economic growth, and thus add more borrowing volumes for banks.
Overall, the promise of tax cuts has yet to arrive for the banking industry when it comes to credit volumes. JPMorgan Chase (JPM) did manage to turn in some impressive lending growth, mostly in credit cards. But the overall financial performance of JPM came due to some one-time events, benefits on the legal expense line and a big pop in principal transactions. Lending fees and loan volumes overall rose a whole 2% year-over-year (YOY).
The Trump tax cuts added four hundred basis points to bank equity returns this quarter, but the top line remains constrained. With EPS of $2.38, JPM’s basic earnings per share rose 40% YOY. Return on equity rose to 15% according to the JPM IR supplement. Notable for readers of The IRA Bank Book, JPM’s interest expense rose 47% in Q1 2018 vs the same period a year before. Meanwhile, interest income increased just 18% year-over-year, resulting in a substantial reduction in net interest margin (NIM).
In many parts of the financial media, you still hear happy talk from economists about expanding net interest margins for banks as the Federal Open Market Committee takes the Treasury yield curve negative. But that clearly is not the case. Economists are often wrong, especially when they wander into the world of finance. Pay attention to this relationship between interest income and expense as 2018 continues and the yield curve flattens, as shown in the FRED chart below.
At Citigroup (C), which like JPM is more market sensitive in terms of liabilities than the industry norm, interest expense rose 44% YOY in Q1 2018. Interest income was up a mere 12% YOY. Other than shrinking NIM, what this suggests, at least for JPM and C – some $4 trillion in assets and the two biggest OTC derivatives shops on the planet – is less return from float going forward. Interest earnings, lest we forget, account for the lion’s share of equity returns in both cases.
But we digress. Aside from the lack of a demand-pull surge from the Trump tax cuts, banks have not seen the increase in corporate investment predicted by so many economists as a result of cash repatriation. In fact, most companies have paid their tax bill w/o moving the cash concerned. As we noted in January of this year ("Tax Cuts, Offshore Cash & Jobs"), this is known as “deemed repatriation” at the Internal Revenue Service.
Another, third, big factor that helped drive the maniac bull rush in financials during 2017 and into February of 2018 was the prospect of deregulation. There have been a number of meaningful changes made since 2016 under administrative rules, in particular the appointment of OMB head Mick Mulvaney to run the Consumer Financial Protection Bureau. But the Trump Administration has been slow to fill regulatory positions, like Fed governors and FDIC directors.
The much awaited financial reform “reform” legislation started with the Choice Act (Versions 1&2) sponsored by House Financial Services Committee Chairman Jeb Hensarling (R-TX) but was quickly narrowed down to what could garner a majority in the Senate. The original Choice Act had a broad reform of the CFPB, which is now totally gone.
Senate Banking Committee Chair Mike Crapo knew that Hensarling’s Choice Act was a non-starter in the Senate. He got together with members of both parties and focused on reform for small banks, which has bipartisan support. The regulatory reform legislation that has passed the Senate is very modest indeed.
The Crapo Senate bill is not a strong, broad reform proposal, but it was supported by 16 Democrats. The result is a very narrow bill which is now pending in the House but has so far not moved from the House Financial Services Committee. The IRA hears from several well-placed sources that any attempt to modify S. 2155 will doom any chances of regulatory reform this year.
For example, the legislation passed by the House to streamline the Volcker Rule is the top priority of the large banks. It may be added to S. 2155 by Chairman Hensarling, but this will likely kill the legislation. So far Hensarling is not "backing down," whatever that means. Just what constituency Hensarling is serving by taking an intransigent position on S. 2155 is debatable, but the fact is that he is one of the least productive House FSC Chairs in recent memory. Hensarling could be noble and get something done as his tenure ends, but few are betting on that outcome.
There are a number of Democratic Senators who signed onto S. 2155 who took a good amount of heat from Senator Elizabeth Warren (D-MA) and other far-left Democrats. And keep in mind that this is really not a Dodd-Frank reform bill as much as relief for small banks and mortgage companies.
There is very little if any lift contained in the Senate legislation to help large banks. And changes to the Volcker Rule are DOA in the Senate. Bottom line: S. 2155 must get passed as is or it will die when it comes back to the Senate with amendments. The bill would get no Democratic support. We do not expect S. 2155 to get out of committee in the House.
Even if Dodd-Frank reform is dead this year, that does not mean that there is no deregulation in Washington. The tenure of Mick Mulvaney as acting director of the CFPB is perhaps the most significant. Mulvaney put a stake in the heart of regulation by enforcement, a key issue for the mortgage industry. Mulvaney says he is not going to use Section 5 of the Federal Trade Commission Act (FTC Act), 15 USC 45(a)(1) (a/k/a “UDAP”), which prohibits "unfair or deceptive acts or practices in or affecting commerce."
The impending $1 billion fine against Wells Fargo (WFC) by the CFPB and the OCC is an example of how Mulvaney will use the power of the CFPB when actual harm is done to consumers. But it needs to be said that the past regime of regulation via enforcement, with no due process or public guidelines for compliance, was outrageous, even by the usually irrational standards used by most progressives.
Most people in the mortgage or consumer finance business, if they make a mistake and a consumer is harmed, they will make good. They don’t need to be sued. By bringing the CFPB into alignment with the FTC and other agencies when it comes to UDAP, Mulvaney has restored some modicum of fairness and balance to an agency that was run more like the Spanish Inquisition, with Richard Cordray as Torquemada.
While having Mick Mulvaney at CFPB is certainly not a bad thing for banks, it is far from the wave of deregulation that was one of the original drivers of the bull market in financials. Indeed, as time slowly runs off the legislative clock, it is increasingly clear that there may be no significant financial reform legislation passed this year. This represents yet another failed promise for financials at a time when sources of support for current market valuations are dwindling.