Thursday, January 19, 2012

Bank Earnings: Traditional Banking Doing Just Fine, Investment Banking Is Not

Bank of America reported earnings this morning reinforcing a clear pattern that has emerged this earnings season among the bigger banks. Investment banking and capital markets results have been weak while more traditional banking* is much stronger.

That has meant the those with a more traditional banking mix, like U.S. Bancorp (USB) and Wells Fargo (WFC), are doing just fine while the likes of Citigroup (C), J.P. Morgan (JPM), and Bank of America (BAC) have been hurt by their sizable investment banking and capital markets operations.

Below are some excerpts from recent articles commenting on bank earnings results (each bank below has at least some traditional banking in its mix). It's clear that, while the traditional banking world still has its problems, the environment continues to improve in a meaningful way.

In contrast, Wall Street businesses continue to struggle.

BofAThe Big Surprise in Bank of America's Earnings
What is clear is Bank of America followed a trend seen at its peers Citigroup and J.P. Morgan. Fourth-quarter results were ugly in its stock-and-bond trading and other Wall Street businesses, but BofA's traditional banking businesses – making loans to businesses and consumers — were stronger.

U.S. BancorpU.S. Bancorp Continues Solid Earnings Generation in 4Q'11
Fitch Ratings notes that U.S. Bancorp's (USB) results continue to outpace those of many of its rivals. USB reported net income of $1.35 billion in fourth quarter 2011 (4Q'11), a solid 6.0% increase from net income of $1.27 billion in the sequential quarter. These earnings equated to a strong 1.62% return on assets and 16.8% return on common equity.

Wells FargoWells Fargo Net Up 20%
Wells Fargo & Co.'s fourth-quarter earnings jumped 20% as the banking giant sold more commercial loans and saw a surge in mortgage creation.

It's traditional banking is doing well differentiating itself from those banks more reliant on investment banking.

CitigroupCitigroup Earnings Fall Short of Expectations
...Citigroup reported fourth-quarter results that fell far short of what analysts were forecasting, despite a pickup in lending and a drop in losses on bad loans. The culprit was the banking giant's capital markets division, where revenue fell 10 percent last quarter as traders headed for the sidelines, hurting businesses like stock and bond trading as well as investment banking.

J.P. MorganJ.P. Morgan Earnings Miss Wall Street Expectations
The big disappointment at J.P. Morgan was the investment bank, and its slide allowed J.P. Morgan's Main Street businesses to take command. J.P. Morgan's division made up of credit cards and auto lending overtook the investment bank in revenue and profit in the fourth quarter.

The net interest margin of Wells Fargo is 3.89% while the net interest margin of U.S. Bancorp is a bit lower but a still impressive 3.6%. On this important measure, both banks have a big advantage over most peers.

Consider that Wells Fargo has typically had a roughly 1% (and even greater) net interest margin advantage compared to other big banks. That may not sound like much but consider this: If Wells Fargo's net interest margin was more like its competitors (something like 1% lower...2.89% instead of 3.89%), the bank would earn $ 11.3 billion less pretax!**

Now, even the best large banks a susceptible to systemic risk. There's no getting around that. The complexity and interconnectedness of large banks making gauging the risks difficult at best (though U.S Bancorp is not exposed to global systemic risk in the same way as someone like Citigroup. It is a much more straightforward banking business). Considering the many other attractive investing alternatives, I can see why an investor would not want to bother with any of these larger banks.

Having said that, banks with higher net interest margins (low cost deposits combined with loans intelligently priced) and other reliable sources of noninterest income can produce above average return on equity (ROE). Banks with relatively high ROE (mid-teens or higher) that maintain a disciplined credit culture throughout the business cycle have a better likelihood of producing above average long-term returns for shareholders.

J.P. Morgan is considered by many to be one of the stronger large banks yet, while the two banks are of course nothing alike, U.S. Bancorp's 16.8% return on equity is more than 2x that of J.P. Morgan. If sustained, that advantage should benefit long-term U.S. Bancorp shareholders in a measurable way.

Even though J.P. Morgan is far larger and certainly more complex (it has a balance sheet that is roughly 7x larger in terms of assets), U.S. Bancorp can hardly be considering small with its $ 340 billion in assets.
(So I'm not really a fan of J.P Morgan due mainly to its complexity, but its shares did seem to get very cheap very recently. It has rallied since but continues to sell at a lower multiple than Wells Fargo or U.S. Bancorp. Still, I'd not be interested in it as a long-term investment. My preference is for less complexity and a bigger emphasis on a more traditional banking model.)

The bad news is, for those that still want to bother investing in one of better large banks, they're much more expensive now. On many occasions these past few years there were opportunities to buy the better banks at very attractive prices (They've gone from being 4 or 5x my estimate of normalized earnings in 2009 to more like 10 or 11x more recently). For my money, an acceptable margin of safety has all but disappeared near current prices.

Of course, as we've seen quite a few times in recent years, that can change pretty fast.

Cheap stocks and good news rarely coincide.

Adam

Long WFC, USB, and JPM bought at much lower prices

* Accumulating deposits then making loans (net interest income) and providing related services (noninterest income) to businesses/consumers.
** Here's another way to look at it. On the same amount of earning assets, the 1% net interest margin advantage enables Wells Fargo to absorb an additional $ 11.3 billion per year of losses before putting a dent in their capital (actually, first it would hit loan loss reserves then equity capital) during times of economic and/or financial stress. So there's a defensive angle to this advantage as well. Some may look at a bank more statically and give less weight to this important dynamic. 

Of course, the loans that go bad are accounted for with a provision for loan losses (a non-cash charge to earnings) that serves to build loan loss reserves on the balance sheet. Then, once a bank is convinced there's no hope of getting paid all or part of what is contractually obligated, loan charge-offs deplete the reserve. No matter how the accounting works, the important point here is that there is an additional $ 11.3 billion available per year to absorb losses on the same amount of earning assets. Finally, a bank can have above average net interest margins but, if it tends to make a lot of dumb loans, at some point this extra capacity to absorb won't be enough. A bank still has to know how to put their money to work intelligently and that means consistently providing credit to borrowers who can handle it.
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