Big Bank Earnings: There's More To It Than You Think This Quarter

Three of the nation's biggest banks kicked off first-quarter earnings season last week. The results were generally positive, with JPMorgan Chase (JPM 2.51%) and Citigroup (C 1.41%) both reporting double-digit bottom-line increases compared to the year-ago quarter. The exception was Wells Fargo (WFC 2.74%), which uncharacteristically reported a year-over-year decline in its quarterly profit.

Listen in to this week's episode of Industry Focus: Financials, where The Motley Fool's Gaby Lapera and John Maxfield dig into the details behind these performances.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped today on Monday, April 17, 2017. My name is Gaby Lapera, and joining me on Skype is John Maxfield, our banking expert extraordinaire. How's it going, John?

John Maxfield: [laughs] I love that introduction, but I think it's probably over billing me. But it's going great, thank you!

Lapera: I'm really glad to hear that. Listeners, I'm really sorry, you might hear me take some extra big deep breaths during this podcast. I had some kind of adverse reaction to a medication, and I think it gave me a touch of asthma. So, sorry in advance about that. Today, we're going to be talking about what else but first-quarter banking results. Aren't you excited? I know I am! How about you, Maxfield?

Maxfield: Snoozer. [laughs] No, that's not true. We're going to talk about some interesting things. So even though, in general, it could be a conversation that could be really boring, I think there's some interesting stuff that listeners will pick up from this.

Lapera: Oh, no, we bring the pizzazz.

Maxfield: [laughs] You bring the pizzazz, I bring the boring. You're here, Gaby.

Lapera: [laughs] So far, JPMorgan, Citi, and Wells have all reported. Bottom lines for JPMorgan and Citi look good.

Maxfield: Yeah, both of them were up 17% on a year-over-year basis. When you're talking the biggest banks in the country, and among the biggest banks in the world, it's not often that you're going to see earnings grow by double-digit percentages on a year-over-year basis.

Lapera: Yeah, that's pretty exciting. We were talking a little bit before the show, and it looks like it's mostly driven through their trading and investment banking. All these big banks, well, Wells kind of, but JPMorgan and Citi especially are universal banks. That means they have two separate arms. They have their retail arm, where they're doing what you traditionally think of as a bank's business, like giving out loans and collecting interest and doing whatever it is that big banks do. The other side of it is this investment-banking side. That's where they saw the big gains this quarter.

Maxfield: Yeah. If you think about where we were at this point last year -- and I want to say, I'm going to be totally selfish here, but there's a part of me that wishes we were where we were at this point last year, because that's where, as an investor, we had gone through a huge correction in the market, and as an investor, that's the absolute best time to be in. Right now, everything looks so expensive, so I'm thinking back so fondly on those days. But if you think back to the first quarter of last year, which is what the banks were comping against in the first quarter of this year, there were two things in particular that really helped those comps shine. The first is that oil prices dipped below $30 a barrel. They got down to around $25 a barrel. And that is really, really low. The problem with that for banks -- even though it's great for consumers -- is that if you lend money to energy companies and the price of oil goes down that far, some of those companies that are operating with really tightened margins aren't going to be able to service their loans. So that made banks increase their loan-loss provisions in anticipation of future loan losses from the energy industry. Oil prices have since been on the mend. So they didn't have that concern this year, so they were able to scale down their provisions. Provisions act on income in the same way that expenses do. So it just freed up a whole bunch of revenue to fall to the bottom line. 

The second point, to the point that you're making, Gaby, is that there is also in that first quarter is when the United Kingdom announced that it was going to have a referendum on whether or not it would stay in the European Union. Now, that actual vote didn't happen until later in the year, but that announcement, in addition to concerns about slowing economic growth in China, caused an enormous amount of volatility in the various types of capital markets, and that translated into lower trading revenues for banks. What banks are is, they help institutional investors buy and sell securities, but when everything's going crazy in the market, those institutional investors step back, which reduces the commission that large, universal banks make from them.

Lapera: Yeah, everyone was kind of in a tizzy at the end of the first quarter of last year. I remember that. I was looking at the show notes from last year around this time, and I was like, "Oh, yeah, I remember." We actually got a listener question about what was going on and we answered it and everything. Times were different then, a whole year ago. But the point that you're making, Maxfield, I think, is that the hurdle, the bar, is low for these banks to succeed year over year, in terms of 2016's first quarter versus 2017's first quarter, right?

Maxfield: That's exactly right. Now, I don't want to be unfair, because JPMorgan Chase, even though, there was an easy comparison in terms of the comps this year compared to last year, it still had a really good quarter. Even in this really difficult and inhospitable environment for banks, it's earning a double-digit return on equity. So let's be fair; it had a good quarter. But it wasn't as amazing as it looks, based on those comps.

Lapera: Yeah, totally fair. So, even though JPMorgan and Citi did generally well, Citi's net interest margin went down. Can you talk a little bit about that?

Maxfield: Yeah, and I'm really glad you brought that up. One of the narratives in the banking industry right now is that banks are going to earn a lot more money as interest rates continue to go up. Since the financial crisis, interest rates have been really low. But in December of 2015, the Federal Reserve increased interest rates by 25 basis points. They did so again in December of last year and did so again one more time in March of this year. When interest rates go up, that means it costs more to borrow. And because the principal product that commercial banks in particular sell are loans, if the prices of those loans go up, that translates into higher revenue. What we're seeing with Citigroup, and we're going to see a lot of that with Bank of America (BAC 3.35%) when it reports earnings tomorrow and throughout the year, because it's come out and said, "Look, on a quarterly basis, just because of that 25 basis points," that's a 0.25% increase in the Fed funds rate, which is the rate that banks lend money, the reserves that are held at the Federal Reserve, if they have excess reserves held there, they lend those reserves out on an overnight basis to other banks that need more liquidity. So as that has gone up, Bank of America is going to make all this additional money. But here's the thing. In Citigroup's case, and JPMorgan Chase is seeing the same thing, and other banks are expected to see that, too, but Citigroup didn't see that, and the reason is because it is still dealing with a lot of churn on its balance sheet related to toxic assets that date back to the financial crisis. So there's all this other noise in the numbers that is disguising the positive impact of higher interest rates on Citigroup's bottom line.

Lapera: Yeah. I will say, it's 2017, it's been a while. You would think they would have sorted through this a little bit quicker, and I think that speaks to the complex structure that Citibank has, that it's so difficult for them to unload these assets, with the regulations on them. But hopefully we see a little bit more hustle on that.

Maxfield: It also speaks to the magnitude of the issues that Citi ran into in the financial crisis. It has taken a long time to work through these things. The other bank that had a similar thing was Bank of America, and it really didn't turn the corner until two years ago. So Citigroup is just a little behind it, but it eventually will turn the corner, and you'll see that in the bottom-line numbers.

Lapera: Yeah, eventually, one day, hopefully. [laughs] The other bank I wanted to talk about is what used to be America's sweetheart of a bank, which is Wells Fargo. They're probably going to be the only big bank to see its earnings decline on a year-over-year basis. Do you think that's related to the account scandal?

Maxfield: I think that it is. Michael Douglass, who is an editor at The Motley Fool, he describes Wells Fargo as "the fallen angel," and I think that's the perfect way to describe it. If you go back 150 years, Wells Fargo has one of the best reputations, and one of the best brands in the bank industry in the United States for a long, long time -- back since the Gold Rush in the late 1840s and 1850s, when it was established. But because of that fake-account scandal that was revealed last September -- thousands of Wells Fargo employees, in an effort to meet sales quotas, in terms of selling additional credit cards, selling additional checking accounts, selling additional savings accounts, they opened up fake accounts for customers that customers either didn't need, didn't approve of, or didn't even know were being opened. So that has really tarnished Wells Fargo's reputation. And if you look at Wells Fargo's numbers from the most recent quarter, it isn't strikingly obvious. It isn't like the revenue fell by 10% as a result of this, or their expenses went up by 20%. It's a much more marginal impact. But what we're seeing is a continued erosion in a number of key metrics at Wells Fargo. The efficiency ratio is a perfect example. It has long been one of the most efficient banks in the country. But because of potential revenue pressure as a result of what happened, the reputational damage it suffered, and that sales scandal last year, combined with the potential that they're going to have to increase their compliance costs, their regulatory costs to deal with that, it's slowly eroding its bottom line at this point.

Lapera: Yeah. And that's something you're just going to have to look out for long-term. The thing with Wells Fargo is that basically all things have been held equal except for the reputational damage that we mentioned from the account scandal. As a result of the account scandal, they changed some of their internal practices for selling, as one might expect, to encourage their employees to stop creating these fraudulent accounts, which means that some of their numbers don't look as good anymore for account openings. Because there's fewer fraudulent accounts. So when you throw all that into the mix, we'll see whether or not Wells Fargo pulls out of it. It's not quite a nosedive yet, but it's definitely something to keep your eye on.

Maxfield: To that point, Gaby, if you listen to Wells Fargo's executives prior to the crisis, for years, they stressed the cross-sell ratio. That is the number of financial products -- so, checking accounts, credit cards, mortgages, all those types of financial products and services -- the number of those that the average customer at Wells Fargo used. And they always trended 2 times, 3 times the industry average in terms of the number of products that each of their customers used. Then, if you listened to the way their executives talk about getting those large cross-sell numbers, what they would do is go after primary checking accounts for a customer, which is the principal banking product, and then build on top of that -- and now, we're seeing new checking account numbers falling on a year-over-year basis by 30%, 40%, new credit card applications at Wells Fargo falling by 40%-plus on a year over year basis -- in the short term, that's not going to have a big impact on their numbers. Because it's not like a bank makes a whole bunch of money when a credit card application is submitted, or any money, quite frankly, or when a new checking account is opened. But it's that deepening of the relationship where the profitability comes from. So the question is, when they announced that they were getting rid of their sales quotas in their branches as a result of the scandal, what is that going to look like over the long term for Wells Fargo, given that its model has been predicated on cross-selling for all of these years?

Lapera: Yeah, definitely. It's an interesting story, and one that we will definitely continue to cover on Industry Focus. One bank that you might notice is missing is Bank of America. That's because they don't report until tomorrow. Overall, I'm kind of expecting to see the same thing going on with Bank of America as you saw with JPMorgan. In fact, they might even do better, because their profitability is so tied to interest rates. And you've talked about before, a little bit of an increase in interest rates means $X billion more of Bank of America.

Maxfield: Yeah. I think that Bank of America is in a stretch right now, where every quarter you're just going to see tangible improvements, and tangible improvements, and tangible improvements. I'm very optimistic, if it wasn't clear, about Bank of America. The one thing I would say, however, that investors should be thinking about with Bank of America and other banks right now, is not so much about their fundamental performance. We were talking about this before the show, Gaby, I don't think that's what's driving their stocks right now. I think what's driving their stocks right now is expectations around policy. When you're listening to the fact that Bank of America is going to have this great fundamental quarter, they seem to be primed for this great fundamental quarter, I would not interpret that, as an investor, to mean that its stock is necessarily going to shoot up after it announces results tomorrow.

Lapera: Yeah, and I definitely want to get into that thing that you alluded to about fundamentals versus policy.

We covered that the first quarter of last year was pretty terrible for banks, so the year-over-year growth looks phenomenal. But there's some other stuff going on with bank stocks. If you've been following the banking sector for at least the last four or five months, you might have noticed that there was something that is now affectionately called the Trump bump, which was right after the election, bank stocks took off. And that's not a coincidence, because one of the things that Trump talked about on the campaign trail over and over again was deregulation and allowing more freedom for the banks. And people drove bank stocks up on the assumption that this regulation was, especially Dodd-Frank, that's really what we're talking about when we say regulation, that that was going to be repealed or changed in such a way that banks would have more freedom, and they were going to be able to drive up their profits.

Maxfield: Yeah. So, what we saw in the election is, bank stocks went up 20%-30% almost immediately. The election happened in November, earnings didn't come out until the middle or beginning of October, and then the Federal Reserve raised rates in December, and then earnings for the fourth quarter didn't come out until January. So there were no fundamental catalysts -- and when I say fundamental catalysts, I mean there was nothing company-specific. It's not like a company came out and said, "We quadrupled our earnings on a year-over-year basis," and everybody thought, "Oh, all banks are going to quadruple their earnings on a year-over-year basis." It was that you had this expectation fueled rally in bank stocks around this idea that if Donald Trump's team at the White House is able to get through easing of the regulations in the banking industry, that that is going to cause profits to go way up.

It's hard to see right now how profits at these banks that are earning more money than they've ever end before. Even Bank of America -- which has dug itself out of the financial crisis but is still deep in the throes of seeing its profitability recover -- even it has shot way up. So the question is, what does that mean for investors? And what it means to me is that you have to be really careful in this zone right now, because I don't think we can expect a 25% boost in profit at these big banks that are earning so much money. And JPMorgan Chase is earning more than it's ever earned on a quarterly basis. It's just hard to understand how, even if there are significant deregulatory moves made in this area, that it's going to have such a huge impact on profits.

Lapera: Yeah. So basically, the stock-price increase is a gamble by investors thinking that these banks will make way more money than they're already making. And as you pointed out, Maxfield, the banks are already making quite a bit of money. So I'm not 100% sure how they would make even more money just like that as soon as deregulation happens. The other thing to think about is, I think there's a post-election high where everyone was like, "Yeah, he's going to get in there, the first 100 days he's going to get a lot pushed through," and the reality is, in Washington D.C., nothing happens quickly. And that's for a reason; that's a protective thing that D.C. has. I know people hate to hear that, but it's good that people can't make rash decisions and changes to legislation, whether or not they're good. This way, it gives everyone a lot of time to consider what the ramifications of any given legislation will be. But that also means that legislation takes a really long time to push through. And banking regulation, as dry and complex as it is, is probably going to take even longer than other types of regulation.

Maxfield: And we saw, with the challenges, trying to get that initial healthcare bill through, that just because there's unity between the branches, Republican-controlled White House, House, and Senate, there are still factions in there that are going to make the legislative agenda difficult to get through. Here is where it gets really dicey for investors. Because bank stocks are up on an expectations-infused rally, it means that investors are thinking and making decisions in the political context. One of the things we know, when a person makes decisions in the political context, is that it is extremely difficult, regardless of which side of the aisle you're on, to make objective, fact-based decisions. In fact, there's this great book, Mistakes Were Made (but Not by Me), that digs into a particular type of behavioral bias known as cognitive dissonance. One of the things that they talk about in that book is, there was a study done where people, Democrats and Republicans, were put into MRIs, and then confronted with information that was either consistent or inconsistent with their political beliefs. And what they saw was, when information that was consistent with your political belief was introduced and you started thinking about it, the area of your brain that is responsible for making deep, analytical insights started firing. But what happened was, if information that you disagreed with politically was introduced, that same area of the brain, they saw, actually shut down. So, what that means is, the way our brain works, when there is information in the political context that we agree with, we incorporate that into our analysis, but the information that we disagree with, we do not incorporate that into our analysis. And in the investing world, which is really unforgiving because you're talking about numbers and money, you need both sides of the story to have a balanced approach.

Lapera: Yeah. And I think I actually see where you're going with this. There was a story out of Wisconsin. I will quote to you part of it. "When GOP voters in Wisconsin were asked last October whether the economy had gotten better or worse over the past year, they said worse, by a margin of 28 points. But when they were asked the very same question last month," in March, "they said better, by a margin of 54 points." That's a net swing of 82% between late October 2016 and mid-March 2017. That's crazy, because there's no way the economy has changed that much between October and March. So it really just comes down to people's perceptions of how the economy is doing. And even more than that, when you ask Democrats that same question, it was basically flipped. Democrats were saying, "We think the economy is way worse; we think a recession is imminent." So this is something that I don't know it's ever been seen before, but we're really letting political activity cloud how we're viewing the economy, which fundamentally can alter how you view investing decisions.

Maxfield: Right, and the Michigan consumer-confidence survey, which is an even broader survey than the Wisconsin survey, it confirmed the same thing. It found a stark partisan divide between how Democrats view the economy and how Republicans view the economy. In fact, I can't remember if it was January or February when it was the largest partisan divide that survey had ever seen, but I think it narrowed a bit in a more recent month, but it's still relatively wide. To your point, what they have seen is, since Donald Trump has taken office, optimism among Republicans has shot way, way up, but among Democrats it has shot way down. So Democrats are expecting, generally, an imminent recession. The data shows they're expecting a recession. The Republicans are expecting a robust recovery. This just goes to the point. I think there's two points here. First, consumer-confidence data is more complicated than the headline number. Second, this goes to the point that when you're in the political realm, even when you're making decisions about things that are non-political, i.e., the economy or investing, politics still creeps in and short-circuits a rational, objective, fact based thought process.

Lapera: Yeah. I mean, honestly, the truth is probably somewhere in between, because that's generally how it goes with these things. But I think the message we're trying to deliver to you, dear listeners, is that you should do your best to make decisions about companies based on the company's fundamentals. Ignore the outside noise. Don't let it creep in. Focus on what you think is good for a company. Don't make bets on what you think other people are going to do. That's how you evaluate a company. That's how you become a long-term thinker and a long-term investor.

Maxfield: And even more generally, Gaby, we know how difficult it is to make accurate forecasts. So when you're investing, being a really good investor isn't necessarily being the one who's able to forecast into the future the most accurately, although that would certainly help. [laughs] It would help, but it's almost pointless to try, because it's a crap shoot, almost, trying to forecast into the future. So, what you see with really good investors, and I think this is what you're saying, is they focus on two things. Look at the quality of the company itself, and whether it has competitive advantages, whether its profitability is on the rise, whether it's run in an efficient manner, and try and look at and compare that to where the valuations are at any given time. And then, focus your analysis around those things, and do your very best to cut out any extraneous noise that could potentially mess up your results.

Lapera: Yes, I 100% agree with you. On that note, I think we're actually done. I think we've run a little bit over. I think we might be boring Austin a little bit. Sorry, Austin!

As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at [email protected], or by tweeting us @MFIndustryFocus. If you want, I can send you those two news articles. They might be behind paywalls; I don't know. I have a ridiculous number of newspaper subscriptions, so I remain uncertain. But I'm more than happy to send you the links about those consumer-index articles. Thank you to John Maxfield for joining us, with your excellent knowledge, as usual. And thanks to Austin Morgan, today's wonderful producer. And thank you to you all for joining us. Everyone, have a great week!