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Introduction

As bank earnings keep pouring in during the start of second-quarter earnings reporting season, one thing is very clear. The second quarter was a great quarter for banks. While many analysts are cheering these results touting an improving economic situation I however am somewhat more skeptical. So I pose this question to my readers. Is improving bank earnings a good sign or merely a lagging indicator? I hope to answer this question in the following article. First let us review some of the earnings data that has been reported by the larger national banks.

Wells Fargo & Co (NYSE:WFC)

WFC reported another quarterly surprise to the upside. It beat estimates on the bottom line, and as you can see from the graph below WFC has been growing both its Net Income and EPS steadily each quarter.

Q2/2012 Q3/2012 Q4/2012 Q1/2013 Q2/2013
Net Income 4.62B 4.94B 5.09B 5.17B 5.52B
EPS $0.82 $0.88 $0.91 $0.92 $0.98

JPMorgan Chase & Co (NYSE:JPM)

JPM Morgan much like WFC also beat earnings estimates. JPM reported EPS of $1.60 beat estimates by $0.16 or slightly more than 10%. JPM just like WFC is showing steady quarter over quarter growth in Net Income as well as EPS

Q2/2012 Q3/2012 Q4/2012 Q1/2013 Q2/2013
Net Income 4.79B 5.51B 5.5B 6.31B 6.31B
EPS $1.21 $1.40 $1.39 $1.59 $1.60

Citigroup Inc (NYSE:C)

C Just like JPM and WFC also beat earnings forecasts. C's EPS of $1.25 beat estimates by $0.07. C has had a more difficult time producing quarter to quarter increases in EPS and Net Income. C is also struggling to produce year over year increases in these same line items.

Q2/2012 Q3/2012 Q4/2012 Q1/2013 Q2/2013
Net Income 2.88B 488M 1.28B 3.8B 4.15B
EPS $0.95 $0.15 $0.39 $1.23 $1.34

Goldman Sachs Group Inc (NYSE:GS)

GS derives most of its income from investment banking services. Although its performance is not as directly related the traditional banking services, GS gives us a look into the performance of investment banking, a sector that should be viewed as an alternative source of funding. Because of its connection to investment banking, GS's EPS and Net Income performance fluctuates more than the other traditional banks listed here, but even GS seems to be on a flat to higher trend for earnings performance.

Q2/2012 Q3/2012 Q4/2012 Q1/2013 Q2/2013
Net Income 962M 1.51B 2.89B 2.26B 1.93B
EPS $1.78 $2.85 $5.60 $4.29 $3.70

Bank of America Corp (NYSE:BAC)

BAC is struggling to grow quarterly profits. Although its Q2 earnings were impressive by recent standards, BAC is still struggling to shed toxic and underperforming assets from its balance sheets. This continues to have adverse affects on its Net Income and EPS performance.

Q2/2012 Q3/2012 Q4/2012 Q1/2013 Q2/2013
Net Income 2.46B 340M 732M 1.48B 4.01B
EPS $0.18 ($0.00) $0.03 $0.10 $0.32

Rising Interest Rates vs Declining Wages

Now that we have seen the Q2 performance for some of the large national banks I would like to address one of the potential drags on future performance, rising interest rates.

(click to enlarge)

As you can see in the chart above fixed rate mortgages have increased to levels last seen in the middle of 2011. ARM loans however have not been impacted as much as fixed rate loans. This may lead to some borrowers choosing the lower interest rate of an ARM over the more reliable fixed rate mortgages. ARM loans are not a problem when an economy is in the midst of wage growth but nominal wage growth over the last 5 years has actually fallen and is not expected to pick back up for some time. This graph from the Economic Policy institute clearly reinforces this point.

(click to enlarge)

The source article for this graph can be viewed here. The other event that these rises in rates may trigger is a slowdown in overall home purchases. According to this article by marketwatch we may already be witnessing this change. Home sales for the month of June dropped 1.2% and came in below consensus expectations. The choices that wait for would-be home buyers are simple, Risky Loan or No New Home. How consumers respond to this newly evolving choice may determine what our economy does over the next 10 years.

Disturbing Profit Trends

One of the largest contributors to the increased earnings for the above banks in the second quarter was that of decreased loan loss provisioning. This means that banks set aside less money for potential loan losses and instead credited it to themselves as profit. The table below shows just how much profit was derived from this book keeping adjustment.

Bank Loan Loss Reserve Adjustments
WFC $500 Million
JPM $950 Million (Real Estate) $550 Million (Card Services)
C $784 Million
BAC $190 million

This is non-organic profit growth. Naturally we would like to see profit growth through organic means. While decreasing loan losses is an admirable goal it cannot be the sole driver of earnings growth.

Summary

As you can see there are some very real headwinds facing both the banking sector and the housing market. Although banks have managed to continue profiting even during times of lackluster economic growth I do feel that margins will continue to be squeezed in the coming quarters. These depressed margins could perhaps cause the financial sector to underperform the broader market. If this does occur I would use this opportunity to possibly add to existing or open new positions in some of these institutions. Please let me know what you think in the comments section below.

Source: Bank Earnings Are Growing - Good Sign Or Lagging Indicator?