U.S. large-cap banks will start reporting their quarterly results next week. Second-quarter results for this year are expected to be deeply impacted by the weakening U.S. economy, involvement of regulators, weakening capital markets, and the European debt crisis. However, some positive impact is expected from relatively healthy U.S. mortgage market activity.
Weakening Economy and the Fed's Involvement
The sluggish U.S. economy is not showing any signs of improvement for the financial sector. The economy is expected to grow by 2% in 2012. The Federal Reserve, in order to simulate growth, has extended "Operation Twist." Besides decreasing interest rates across the board, this operation is aimed at flattening the yield curve, so that corporations and home owners can borrow at cheap rates. Banks that are more sensitive to interest, and rely heavily on interest income, are the ones poised to feel the brunt of the damage. However, much depends on how much the Fed succeeds in flattening the yield curve. Citigroup Inc. (C), the Bank of America Corporation (BAC), Wells Fargo & Company (WFC), and JPMorgan Chase & Co. (JPM), are expected to be adversely affected by the Fed's actions. Qineqt's estimates show that Citigroup relies heavily on interest income, as over 70% of its revenue comes from interest income. Similarly, 57% of Bank of America's revenue comes from interest income, followed by Wells Fargo and JPMorgan, which each have exposed 50% of their revenue to interest income. Banks that will least be affected by the decreasing interest rates and flattening yield curve are Goldman Sachs Group, Inc. (GS) and Morgan Stanley (MS), since their revenue is 24% and 18% exposed to interest income.
Weaker capital markets activity will affect Citigroup, Bank of America and JPMorgan.
These are volatile times with respect to capital market activity, where the risk of outsized losses runs high. S&P 500 trading volumes are on the lighter side as well. According to data released by Bloomberg, average daily U.S. trading volume for 2012 is till down 44% from its 2008 highs. Moody's, a premier American credit rating agency, trimmed credit ratings on June 31, 2012, for all U.S. banks with significant global capital market exposure. Consistent with our view, Moody's suggests that these banks will be adversely affected by the volatility risk of massive losses associated with the current weak capital market conditions. Among the five large-cap U.S. banks that received the cut, Bank of America received the least cut (one notch), while Morgan Stanley was the only bank that received a less-than-expected cut (two notch cut rather than the expected three). JPMorgan, Citigroup and Goldman Sachs all received a two-notch cut reflecting their relative exposures. These sluggish trends will have a direct adverse impact on the investment banking divisions of large-cap banks. Analysts at Credit Suisse view that the overall investment banking revenue for large-cap U.S. banks will drop by 16% QoQ, with Bank of America taking the largest hit of a 19% drop in its revenue accruing from investment banking.
Healthy Mortgage Banking Activity - Wells Fargo to Post Strongest Results
Healthy mortgage activity, represented by low mortgage rates, strong mortgage origination volumes, accelerated refinancing largely due to HARP, and increased gain on sale margins, are all encouraging trends for large-cap banks going forward.
Mortgage rates fell to record lows, providing home buyers an incentive to improve the recovering housing market. The 30-year mortgage rate plunged to 3.62%, as illustrated in the graph below.
Strong mortgage origination volumes, as suggested by Mortgage Banking Association (MBA), are forecast to experience a 2.5% increase in mortgage originations in 2Q2012 to reach $372b. This increase is largely considered to be driven by purchase volumes (7%), and only 1% by refinancing volumes.
Both record-low mortgage rates and government sponsored programs like the Home Affordable Refinance Program (HARP), which has allowed underwater mortgages to be refinanced at lower mortgage rates, have contributed to the increased refinancing activity. A 50% increase in mortgage refinancing has been witnessed since the last fall. Most of the demand is coming from underwater mortgages.
The graph above shows how home prices in the U.S. have increased over the last two quarters. The U.S. home price, represented by the Case-Shiller Home Price Index, is at 138.55 as of July, up from June's 137.63. This improvement in prices will help banks increase gain on sales margins.
Banks that have the largest exposure to real estate markets are expected to benefit the most. Wells Fargo already has the largest share of 33% in mortgage originations in the U.S.
Rising expenses have been adding pressure on large-cap banks. Therefore, cost-cutting programs run by all major large-cap banks in the U.S. are going to play a key role in enhancing earnings for these banks in the coming quarters. BAC has initiated its company-wide cost cutting program named "New BAC," through which it aims to shed 30,000 consumer banking jobs over the next several quarters. It will also cut up to 400 positions in its corporate banking, investment banking, and trading and sales units. With the expected sale of its non-U.S. wealth management division, the bank will get rid of another 2,000 jobs. The bank reported $1.91b in expenses in 1Q2012. Owing to the success of this initiative, expenses are expected to be considerably less this quarter.
Similarly, Goldman Sachs was able to reduce its expenses by 14% to $6.77b, over last year's first quarter. Under its cost cutting initiative, the company shed 8% of its workforce during the last year. A continuation of such initiatives will enhance margins for the bank.
Wells Fargo's Project Compass is expected to result in cost savings of $1.5b for the bank, by the end of 2012. This company-wide cost cutting program is aimed at targeting non-interest income and boosting efficiency.
2Q2012 Estimates VS 1Q2012.
Bank of America Corp.
Bank of America is poised to be adversely impacted by the flattening of the yield curve. However, its cost cutting initiative under the New BAC program will partially offset the impact. The bank has a large exposure to the global capital market, which will also adversely affect its results. Consensus earnings estimates for Bank of America are at $0.16. The bank's total revenue is expected to decline by 14%-18% QoQ, primarily due to a decline in trading, investment banking and squeezed interest margins. The bank's trading revenue accruing from trading and investment banking is expected to decline by 30%- 34% and 18%-21% QoQ, respectively, due to reasons cited in the capital markets sections above. Net interest margin for the bank is anticipated to drop by 10-50 bps. The forecast tangible book value for the bank is $12.5 to $13.5 per share.
Wells Fargo & Company
When Wells Fargo reports its 2Q2012 results on July 13, 2012, it is expected to show strong growth due to its enormous exposure in the U.S. real estate markets, and favorable recent trends in housing. Its cost-cutting initiative, under Project Compass, will add further to 2Q2012 results. Analysts have a consensus estimate of $0.84 for Wells Fargo's EPS, on $21.8b of anticipated revenue. The 100bps improvement in revenue will be partially offset by the pressure on net interest margin, which will decline by 5-10bps due to reasons cited in the "Weakening Economy and the Fed's involvement" section above. An overall 8%-12% QoQ improvement in revenue accruing from the mortgage banking division of the bank is expected, due to reasons mentioned in the "Healthy Mortgage Banking Activity" section given above. A decline of 32%-36% in trading revenue, driven by reasons mentioned in the "Weaker Capital Markets Activity" section, is also expected.
Citigroup is expected to suffer a hit from the flattening of the yield curve, and a decrease in interest rates. Citigroup, with consensus EPS estimates decreasing by 14% QoQ to reach $0.92, is expected to post $19.85b in total revenue. Revenue accruing from the bank's securities and banking division are anticipated to drop by 25%-30% QoQ.
JPMorgan Chase & Co.
JPMorgan is anticipated to post $0.68 of EPS on revenue of $21.9b. Revenue from the trading segment are anticipated to decline by 30%-34% compared with 1Q2012. Projected fixed income and equity trading will be down by 34%-37% and 15%-25% respectively. Revenue accruing from investment banking will also be down by 13%-20%.