This year's earnings for the big banks were very noisy. On the negative side they included litigation costs, losses on revaluations of their own debt, and some repositioning costs, and further pressure on net interest margins. On the positive side there were large reversals of loan loss reserves, tax benefits and gains on private equity and debt securities. There are those who worry that those positives are not repeatable, and the negatives could continue into 2014. To that worry, I would add that the Volcker rule comes into effect this summer and could put further pressure on the sales and trading revenues of the investment banking operations. Balancing those worries is the hope that some day rising short term interest rates will allow net interest margins return to historic levels, and that the constant barrage of litigation will end. Adjusting for the noise, and for the revenue potential under the Volcker rule and in a higher rate environment, we get a sense of "normalized" earnings. Based on those "normalized" earnings, it is clear that the recovery for some of the big banks still has substantially further to go, so that even without a multiple expansion, their share prices can provide good returns. Others, like the pure investment banks, are in danger of seeing their business shrink, so that without further cost controls and major share repurchases (which are very possible), so they could be less rewarding investments.
2013 Earnings Noise
Bank of America
Debt and Equity gains
Loss reserve reversal
Wither loan loss provisions?
The incontrovertibly positive development is that loan quality improved materially in 2013. In particular, time and the appreciation in the value of houses has brought loss rates in residential mortgages down sharply, though they are still well above historical norms. Winnowing out the riskier borrowers has brought credit card loss rates back down into the 3.5% range not seen since the early 1990s. Strong recoveries reduced net loss rates in commercial loans and real estate to rates well below historic averages.
In response to these improving conditions, banks reversed previously established reserves by provisioning less that they were charging off. The reserve reversals are not really quality earnings in that they cannot go on forever. That said, reserves are still conservative, varying between 2 and 3 times the current run rate of charge-offs. Those banks with the higher reserve multiples, like Wells Fargo (NYSE:WFC), PNC Financial (NYSE:PNC) and Citigroup (NYSE:C), have room to reduce reserves further.
The other component in determining what provision levels will be is the net charge-off rate. While the residential mortgage loss rates have further progress to make, the other loan categories, especially credit cards and commercial loans, could actually produce higher losses in the future. Therefore, based upon their loan mixes, I estimate that JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC) could see losses climb, while the other large banks could see further declines.
Is relief in sight on the litigation front?
2013 saw some major settlements so we can hope that future litigation costs will at least be lower. The six largest banks in the US expensed $20.9 billion in legal costs in 2013, of which JPM accounted for $11 billion. That brought the total to $115.5 billion of costs since 2008, or more than a year's worth of their collective pretax income. (As an aside, that is 41% of their tangible equity at the end of 2008. It is amazing there is still a banking system left.) About $46 billion of that was earmarked to settle claims of inaccurate representations of the quality of mortgages securitized-mostly by the government housing agencies, like Fannie Mae, Freddie Mac. The rest involved penalties for improper mortgage processing, and various regulatory fines. Still outstanding are suits by private investors for alleged misrepresentations of loans underlying securitizations, and a growing number of claims about rigging Libor, currency or other markets. Thus, managements of the banks have warned that legal costs will remain "elevated", if hopefully lower than in prior years. While the big chunk of legal costs may be behind the banks, I would not look for complete relief for the next couple of years.
Net interest income remains pinched by low short term rates
The relentless narrowing of net interest margins continued in the fourth quarter with no end in sight until short term rates rise. Most banks are fundamentally asset sensitive, meaning they benefit from rising rates, because they fund their loans and investments partly with non-interest bearing sources of funds, like checking deposits and equity. When the rates they earn on assets sink, that goes to the bottom line because there is no matching decline in funding costs.
Margin compression had the effect of reducing net interest income even in the face of reviving loan growth.
Investment banking treads water in the face of regulatory changes
Investment banking operations hung in even though fixed income markets were unsettled in anticipation of Fed actions. Fixed income trading was down about 10% on the full year for the five major banks, JPM, Goldman Sachs Group (NYSE:GS), Morgan Stanley (NYSE:MS), BAC, and C, replaced in part by a 10% increase in equity trading.
At the same time underwriting revenues improved on the fourth quarter and the year as IPO activity picked up in a strong stock market. Economic growth should propel these revenues higher.
Taking all investment banking operations together, revenues have not exhibited any secular trend since the crisis, even though banks have abandoned their proprietary trading desks and are paring down some of the activities that attract a lot of risk capital, like trading in physical commodities. In addition, they are exiting hedge fund ownership interests, and private equity holdings that have yielded substantial profits in the past. The Volcker rule becomes effective this summer and could have a material impact on sales and trading activities. Every move by traders will be second guessed as to whether it qualifies as genuine market making or constitutes a proprietary position. It is impossible to tell what the impact will be, but it could dampen the desire to engage in thinly margined trades.
Regulatory Capital Targets Met
Banks have hit their most stringent regulatory capital bogies, which are the fully phased in Basel III tier 1 capital target of 9.5% for the systemically important ones. With banks still trying to optimize their businesses to ensure that they provide adequate returns on risk capital, risk weighted assets are not growing very rapidly and in some cases are declining. This raises the prospect that this year banks will be able to up their returns to shareholders. The Fed is due to opine on plans that banks have submitted to repurchase shares or increase dividends this spring.
Taking all the above issues together, it is possible to create a calculation of what normalized earnings would be. To do so I make the following assumptions:
- Net interest margins return to 2011 levels
- Provisions fully cover a normalized charge-off level of: .2% on residential mortgages, 4.5% on credit cards, .4% on other consumer loans, .75% on commercial loans.
- Expense ratios level with those of 2013 except for MS, BAC and C, which have realized on cost cutting plans.
- Trading income at 90% of 2013 levels to reflect the impact of Volcker
- No gains on private equity or hedge fund ownership to reflect a post Volcker world
- No litigation costs
- Share repurchased of $4 billion and $7 billion, respectively for MS and GS, which are arguably overcapitalized especially as they pare down in the face of the Volcker rule.
Changes to 2013 income assuming normal conditions
Bank of America
Net interest income
Debt and Equity gains
Credit loss provisions
Loss reserve reversal
Operating pretax income
*DVA, gains on sale, repositioning costs
Valuations based on normalized earnings
While a return to "normalized" earnings is not in the cards immediately, it is useful to think about valuations based upon those earnings. The picture that emerges is that some banks will benefit, while others will be hurt. The pure investment banks, MS and GS, could shrink, so that, other than further improvements in the profitability of MS retail brokerage activities, their underlying profits may not grow. Those banks, like JPM and WFC who could see a 50 bp increase in net interest margins, would benefit hugely. That would swamp the growth of provisions, even for those whose loan reversals were highest, like JPM and BAC.
I assume that P/E ratios will be 11 for those capable earning 12% ROE, 10 for the lower earners and 12 or 13 for the higher earners. Those, like MS, whose current valuation is at 13 times normalized earnings, and GS, which could be hardest hit by the Volcker rule, seem to offer little appreciation potential. The commercial banks, especially JPM and WFC, in theory offer the greatest potential. The caveat is that it depends on interest margin expansion and an end to litigation, which may take a while.
Bank of America
While this exercise is theoretical, it provides support to the notion that one should be cautious in the face of the Volcker rule implementation and that enthusiasm over an end to litigation may be overdone. I would stick with the quality names that have less of those issues, like WFC and PNC Financial .