Big Banks, Big Earnings: A Review of Q4

With earnings season in full swing, we now have a good sense for how the nation's biggest banks performed in the final months of 2016.

As The Motley Fool's Michael Douglass and contributor John Maxfield discuss on this week's episode of Industry Focus: Financials, two of the nation's biggest banks had breakout quarters, while two more reported particularly dismal results. Listen in to hear why, as well as to learn the one bank stock they think is best positioned to benefit going forward.

A full transcript follows the video.

This podcast was recorded on Jan. 23, 2017.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, Jan. 23, and we're talking big bank earnings. I'm your host, Michael Douglass -- Gaby Lapera has a cold -- and I'm joined on Skype by fool.com's banking expert, John Maxfield. John, it's good to be able to talk to you again on the podcast. It's been a little while.

John Maxfield: It has been way too long, Michael. What were we just talking about before the show? Was it two years ago since we did this show together?

Douglass: [laughs] Something like that, it was scarily long ago. Fortunately, the podcast has improved. I'm not sure I have. But listeners, listen, send us an email at [email protected] if you think that, with me here, we sound reasonably good. Help me out here, give me a small ego boost.

Maxfield: Be kind, be kind to him!

Douglass: Yeah, please be kind! [laughs] All right, let's talk about bank earnings. Before we get into specific banks, let's talk about the big overall drivers. The first one, of course, trading revenue.

Maxfield: Yeah. This was one of those quarters where a ton of stuff happened in it. But, if there was one thing in particular that impacted bank stocks, it was the presidential election. The reason the presidential election impacted bank stocks -- or, one of the principal reasons -- was because it caused trading revenues at these large universal banks, which are banks that have both commercial banking operations and investment banking operations to soar by double digits on a year-over-year basis. And the reason trading revenue soared on a year-over-year basis as a result of the election was because institutional investors had to reposition their portfolios in the wake of the election because of the unexpected outcome. Anytime you have institutional investors in the market buying and selling different types of securities because banks are market makers, i.e., the ones that are facilitating those transactions, and they earn commission on those transactions, they're going to make a lot more money. That's one of the principal reasons it was such a good quarter for these big banks.

Douglass: Right. Certainly, bank stocks moved a great deal after the election because of expectations of deregulation, and perhaps some expectations that things like trading revenue would improve, but this is where we actually get to see some of that fall through to the bottom line. It's like, trading revenue was actually boosted by quite a bit.

Maxfield: Yeah, that's a really good point, actually, Michael. If you look at the stock prices, they shot up 25% to 30%. And that was because of the expectation for reduced regulations and all these things that could happen under the new presidential administration. But if you're talking about the fundamentals of the bank, to your point, it was the trading revenues.

Douglass: Exactly. Let's also talking short-term and long-term interest rates. People always talk about interest rates like they're one thing, but there are two different main streams to talk about.

Maxfield: Yeah. If you think about banks, what are banks? The way I like to simplify in my own head, because I have a pretty simple mind [laughs], is that a bank is really nothing more than a retail type of operation, but instead of a bookstore that sells books, banks sell money. And interest rates are the price of money. I.e., when you get a loan, the bank is basically selling you that money to use for a time being. The price that you are paying for that is the interest rate on that. So, as interest rates go up, the price of money goes up. And as the price of money goes up, well, so do bank revenues. So, that is a really good thing. But here's the thing. The banks have been talking now for a few years, waiting for interest rates to come up, hoping for them to come up because profitability in the sector has been so hard. But, in the fourth quarter, when they did come up, the short-term rates didn't come up until December, when the Federal Reserve, the committee that sets monetary policy, when they decided to increase interest rates, that didn't happen until December, so, a little bit more than two-thirds of the way through the quarter.

Long-term interest rates, which are also are beneficial to banks, they shot up in the immediate wake of the election, just like bank stocks did. And they shot up, actually, by quite a bit, by 90 basis points. If you talk about that on a percentage basis, that means 0.9%. Now, that doesn't seem like a lot. But if you look at all these banks, in their regulatory filings, put out interest rate sensitivity analysis. And Bank of America (BAC 3.35%) said that, if short and long-term interest rates increase by 100 basis points, which is almost how much long-term rates shot up, it would earn $5.3 billion more over the following 12 months in net interest income. And net interest income is really high-margin revenue that essentially just falls to the bottom line. Then, we factor in that a bank like Bank of America makes like $5 billion a quarter, then basically, just by interest rates increasing by 1% would basically give Bank of America a full 'nother quarter of earnings on top of what it's already earning. So, it is a really big thing. But, because they came up so late in the quarter, the banks really aren't going to see that benefit until this year. That's why, I think, investors can and should feel bullish about bank stocks at this point.

Douglass: Yeah. Certainly, those year-over-year comparisons look like they're going to look pretty darn good for the rest of 2017. Of course, no one has a crystal ball and can predict the future. But that's what things look like right now. But, an interesting thing about interest rates -- and John, you and I were talking about this a bit before the show -- earnings obviously improve as interest rates go up, or they tend to, but book value will tend to go down. Why is that?

Maxfield: When you think about what a bank is, it's a highly leveraged investment fund. And in that fund, it holds two different types of assets. I'm speaking very generally. One type of asset are loans. The other type of assets are fixed income securities, things like a 10-year Treasury bill, mortgage-backed securities that are issued by Fannie Mae and Freddie Mac, things like that. Well, as interest rates come up, the value of the securities comes down, because those securities were issued under lower interest rates. So, as the new securities, which are basically fungible -- a 10-year Treasury issued in December for all intents and purposes isn't really different from a 10-year Treasury issued in October, except for the fact that if the interest rates go up, investors are going to earn a lot more from those, so they're going to be willing to pay more for those securities that are issued in a higher interest rate environment. What happens then is that all those securities that were existing and on their portfolio, their prices go down.

So, what we saw in the fourth quarter was -- and this is a statistic that Dick Bove, a well-known bank analyst, publicized in a recent report, is that if you look at 18 of the biggest banks in the United States, the ones that have thus far reported their earnings, their cumulative book values have fallen by between $17 [billion] to $18 billion. Now, here's the interesting thing about that. You think that there's some give and take here, higher interest rates are good for the income statement but they're bad for the balance sheet. But here's what's so interesting about this. Because of where we are right now, and because the way the regulatory environment has unfolded over the last few years, banks have to hold so much capital that it makes them look less profitable. Because, the way that banks estimate profitability is through the return on equity calculation, where you have income divided by capital. If you have more capital, then your return on equity is going to go down. So, what has happened now is, as these banks have had to revalue their portfolios down, that is actually going to make them look even more profitable, because their return on equity is going to go up. So, there's all these different moving pieces when you're talking about interest rates. Some are good, some are bad. But it looks to me like -- and I think this is probably the consensus out there -- is that as a general rule, higher interest rates are almost indisputably good for banks.

Douglass: Yeah. On balance, a net positive. John, I like to talk, and I know you do, sometimes, too. So, I'm going to go ahead and institute a 30-second rule. We're going to talk about three big banks and we're going to talk about each of them in 30 seconds. Sounds good?

Maxfield: That sounds great.

Douglass: OK, let's talk specifically Bank of America, go.

Maxfield: Awesome quarter. $4.3 billion in net income applicable to common stockholders. 50% better than the fourth quarters in the average of the four quarters in the three preceding years. That's great. They are boosted by trading revenue in particular. Going forward, they're going to earn a lot more money, to the point we made about interest rates, $600 million more per quarter this year, if everything else stays equal. However, the one thing that remains out there for Bank of America is that it still needs to get its profitability up. But, it's going in the right direction.

Douglass: Cool. JPMorgan (JPM 2.51%). And, I'll go ahead and insert here, wow, what a barnburner of a quarter for them.

Maxfield: [laughs] Yeah. Monster quarter. I mean, JPMorgan Chase earned $6.7 billion. Let me put this in perspective. If you look at earnings over the last 12 months of all the companies on the S&P 500, only one company in the United States earns more money, that's Apple. So, what we're seeing now is the true value of the franchise that CEO Jamie Dimon has built. He built it in large part during the financial crisis by buying a number of other banks for pennies on the dollar. We're really starting to see that value come to fruition.

Douglass: All right. Citigroup (C 1.41%)?

Maxfield: Citigroup had a really tough quarter. If you just look at its top-line revenue, it fell on a year-over-year basis. Anytime revenue falls on a year-over-year basis, that's not good, particularly when you consider that Citigroup has substantial trading operations that also benefited from trading. So, the fact that they benefited from that, but everything else fell, was not a good sign. The one thing I would say about Citi that shareholders should take note of is that the fourth quarter was the last time that it will separately report the performance of Citi Holdings, which was the entity that it created after the financial crisis, and stuffed full of toxic non-core assets. So, it marks a demarcation point between Citi and the financial crisis that basically, going forward, it will be difficult to even tease out the impact of the financial crisis from Citi's financial statements any longer.

Douglass: Let's talk about Wells Fargo (WFC 2.74%), the fallen angel of the big bank stocks. What happened with these guys?

Maxfield: Wells Fargo had a really tough quarter. Like I was telling you, it kind of reminded me of my first semester in college. I still had a pretty good semester, but it was pretty messy when you looked at all the details. In fact, my parents probably didn't know too much about that. [laughs] But, anyway, Wells Fargo has struggled in the quarter. We saw that scandal come out. And that really impacted its top and bottom lines.

Douglass: Yeah. Let's face it, reduced credit card and checking account deposits, that's going to be a problem long-term. And all of that work that they're having to do, trying to respond to everything that happened. Let's go ahead and take a step back for those of our listeners who might not be familiar with what's going on with Wells Fargo over the last six months.

Maxfield: In September, the Consumer Financial Protection Bureau came out and revealed that Wells Fargo, employees in its branches, had been opening fake accounts for customers in order to boost Wells Fargo's cross-sell ratio, and on the individual basis, when you look at the bankers who were doing it, it was in order to meet their sales quotas, these really high sales quotas that they were obligated to meet in order to win bonuses and also to keep their jobs. So, that came out. And then, later in the month, the Office of the Comptroller Currency, which is the primary regulator for national banks, because of the scandal, it is now requiring Wells Fargo to seek regulatory approval for any changes in officers and directors. When you think about it, the company can't even hire or fire the main people anymore without the regulators weighing in on it. That's a pretty stiff penalty. Then, later in the quarter, in December, the Federal Reserve came in and said that Wells Fargo had messed up on this really important financial submission that all the big banks have to submit each year, and as a result of it being the only large bank in the United States to mess up on that, it can't expand internationally without regulatory approval, and also can't make acquisitions without regulatory approval. And then, the icing on the cake -- what a horrible cake it would be to eat -- is there are all these ongoing investigations into Wells Fargo. The one that we know for sure is going on is being run by the SEC, the Securities and Exchange Commission, that is looking into whether Wells Fargo retaliated against employees who tried to bring that sales scandal to light over the past few years as it was happening, and then when they did bring it to the attention of their supervisors, it is alleged by many, many employees and the media over the last few months that they were either fired, or faced some sort of adverse employment action as a result of bringing it to light.

Douglass: Yeah, just a multilayered cake of bad stuff going on. That's pretty much the Wells story in a nutshell. Let's widen back out. Going forward over the next couple quarters, and the rest of 2017, even, what are the major things folks should be watching for across big banks?

Maxfield: The major things you're going to want to be watching are, I would say, you're going to want to watch, for sure, the direction of interest rates. When the Federal Reserve met in December, they raised interest rates, the short-term interest rates, the Fed Funds rate, by 25 basis points. But they also said, "Look, a plurality of members on that committee thinks that they will raise interest rates three more times this year." To put that in perspective, the Fed has only increased rates twice since the financial crisis eight years ago. So, that would be a huge boost to banks if that were to come to fruition. The other thing to listen and watch for are the language coming out of the presidential administration about what steps they're going to take on the regulatory front, and what impacts that will have on banks. As I'm looking at it -- and just today, Trump came out and said that they're going to decrease regulations, and I don't know how you'd quantify this, but by 75% -- well, if they do that in the bank industry, which is one of the most heavily regulated industries in the United States, banks are going to earn more revenue, they're going to have lower compliance costs, and their profitabilities are just going to soar.

Douglass: We're an investing podcast, so if you had to pick one of the big four we talked about today -- that's Bank of America, Citigroup, Wells Fargo, and JPMorgan -- if you had to pick one right now as your favorite big bank stock, which would it be?

Maxfield: I would have to say -- it's tempting to say that Citigroup is because the value of the stock is so low. But the problem with Citigroup is -- and we detailed this earlier in the show -- is that it's going to struggle going forward, particularly, to get back to the policy question, if the presidential administration goes in a protectionist direction, because Citigroup is such an internationally focused bank, that could really impact it. So, even though Citigroup is the cheapest, I don't think that's the direction that I would go in as an investor. The direction I would go in as an investor at this point is JPMorgan Chase. Again, to the point we made earlier, because the value of that franchise ... as these interest rates come up, and assuming that they do, the value of that franchise is really going to come through. And it is now, as of the fourth quarter, the most profitable multitrillion dollar bank in the quarter. And going forward, I just don't see that trend abating at all.

Douglass: Good thing to end on. Always like to end on a high note. Well, listeners, that does it for this episode of Industry Focus. If you have any questions, or you just want to reach out and say, "Hey," shoot us an email at [email protected], or tweet us @MFIndustryFocus. I can tell you, the reason that those of you who are listening from Friday and saying, "Wow, Michael seems to be on here a lot," Friday, we had gotten some listener questions on the Tech show -- Dylan Lewis and I had been talking a lot about how we invested, and somebody wanted us to do an episode specifically about how we thought about investing in stocks, and we were happy to oblige. So, drop us a note, shoot us a tweet. We love to hear from our listeners. If you're looking for more of our stuff, of course, subscribe on iTunes or check out The Fool's family of shows at fool.com/podcasts. Be sure to leave us a review. It helps us make sure that we can get our message out to more people.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For John Maxfield, I'm Michael Douglass, thanks for listening and Fool on!