Banks are feeling the pressure this week, as a lack of bond-trading revenue is expected to ding Q3 earnings for the industry's elite. This news, coupled with a slowdown in mortgage loan originations might be something for you to consider with one week left in the third quarter, and earnings season about to begin. With that said, how should you play bank earnings for the coming quarter?
The process of creating revenue for banks, and assessing the fundamentals of a bank, has become increasingly difficult amid new regulations following the financial crisis. Over the last year, money center banks, regional banks, and even investment banks have been among the market's best performing groups of stocks. Yet, the origination of mortgages and revenue from security trading/investing is very important, and both sectors are looking particularly bleak.
It was fun while it lasted
The mortgage segment has been a surprising strength of the financial industry over the last year. A combination of record low interest rates and the Home Mortgage Refinance Program created a temporary boost in the number of home owners who refinanced their mortgage, and sparked an impressive period of new loans as well.
However, last month the Mortgage Bankers Association released its finance [pdf] forecast for new mortgages, which showed a year-over-year decline of more than $250 billion from 2012 to 2013. Such forecasts have been seen in the past, but have been overlooked due to the apparent strength of the industry, and the large stock gains within the sector.
But now, we are seeing strong signs that this weakness is upon us. Wells Fargo (WFC) is the top U.S. bank in mortgage originations, $125 billion last year. However, recent actions taken on behalf of the company suggests that demand is crippling.
Last week, Wells Fargo announced plans to lay off 1,800 mortgage production jobs, which added to the 2,300 jobs that had already been cut in the third quarter alone. Investors should note that such a drastic move is usually intended to quickly cut costs, signaling demand declines at a faster-than-expected rate. This fact might be a warning sign ahead of the company's Q3 report, and leaves a lot of uncertainty surrounding its guidance.
Investors aren't trading!
One major way that banks make money is by selling financial products. Theoretically, trading volume is lucrative for banks. Thus, the warning on Citigroup (C) sent chills throughout the industry during Monday's trading.
While Wells Fargo is the largest mortgage originator in the U.S., and is a good gauge of the segment; Citigroup is a great gauge of trade, due to having the largest exposure to emerging markets .
Reportedly, Citi's trading revenue is expected to fall sharply, as volume was weak in the third quarter, insinuating that customers were not as active in trade. Moreover, the Fed's non-taper decision weighed on the segment, as Citi was expecting higher trading volume.
After having conversations with investors, some analysts believe Citi's total revenue could see a 10% drop in Q3. Seeing as how all large banks have a trading division, the news regarding Citi's revenue will likely be felt industrywide, especially with investment banks.
Already, both Barclays (BCS) and Credit Suisse have issued warnings similar to Citi. Barclays noted the months of July and August having low trading volumes as a result of fixed-income revenue. The following chart shows the rate of decline for trading in the third quarter compared with last year.
Volume Declines Year-Over-Year
A Third-Quarter Reflection
While each issue is focused on an individual company, these two problems are harmful to the industry. For example, JPMorgan (JPM) warned investors in early September that it would post a net operating loss for the second half of 2013 in its mortgage business. However, JPMorgan also has a massive trading operation, meaning it accumulates loss on both ends (mortgage and investments).
For companies such as Wells Fargo, JPMorgan, and Citi, analysts can try to decipher various indications of performance, but it is really hard to know precisely how these banks will perform until earnings season. Then, when dealing with regional banks this assessment becomes even harder, because a strong or weak region might perform better or worse than larger banks.
In particular, BB&T (BBT) CFO Daryl Bible talked about "migrating" mortgage origination employees to a company subsidiary. Then, "right-sizing the business" in the first-half of 2014. While such comments leave more questions than answers, investors can still conclude that BB&T is seeing some weakness but maybe not enough to make any substantial moves. Still, this makes earnings season very uncertain, and trying to determine an outlook near impossible.
Looking ahead, you really have to view the financial industry with a glass half empty mentality going into earnings season. Not only do we have to worry about this upcoming quarter and its weak performance, but we have no idea what guidance or future cost-cutting measures will produce.
Hence, the best way to play financials right now is to be highly skeptical. The last couple years have been exciting, producing large gains, and maybe you were lucky enough to refinance your mortgage with record low rates. But now, the tide is turning, and there are more than enough warning signs that the next few months will not be pretty in this industry.