A Big Quarter for Bank Stocks: Here's What to Expect

All of the big banks announce earnings over the next week, with JPMorgan Chase (NYSE: JPM  ) kicking things off tomorrow.

What should you expect?                                                                        

Here are three areas I'd pay special attention to.

1. Fixed-income trading
Fixed-income trading has singlehandedly kept banks' bottom lines intact for the past 15 months. Chalk this up to an exceptionally fat yield curve, a government that can't sell enough Treasuries, and consumers plowing headlong into the anticipated safety of bonds.

That this gravy train will end is guaranteed; when is the question. Although no one knows, there's one reason to think this quarter's fixed-income profits will keep up with the previous trend: Jefferies.

Jefferies is a small New York bank that gets zero attention, yet operationally it looks a lot like Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) . It reported second-quarter earnings three weeks ago, providing a sneak preview into the industry.

Jefferies increased fixed-income trading revenues by 8.2% sequentially. This doesn't guarantee anything for other banks, but it suggests that industrywide fixed-income profits won't stray far from their recent averages. Fixed-income profits are primarily driven by macro factors, not the talent of individual banks, so it's fair to extrapolate one bank's results to the rest of the industry.

Here's how fixed-income trading contributed to the big picture during the first quarter:

Company

Q1 2010 Fixed-Income Trading Revenue
as % of Total Revenue

Goldman Sachs

58%

Morgan Stanley

30%

Citigroup (NYSE: C  )

21%

JPMorgan Chase

20%

Bank of America (NYSE: BAC  )

17%

Source: Company filings, author's calculations.

2. Blown-out debt spreads
When banks look like they're in trouble, the value of their debt falls. Under one of the nuttiest accounting rules known to man, they're then allowed to count this event as net income. The idea is that a bank could theoretically buy back its own debt at a discount, hence creating value for its shareholders. (I don't get it either.)

Banks were stung by several setbacks in the second quarter, including Greek mayhem, a dawdling recovery, and uncertainty over financial reform. That sent their credit default swaps soaring, which implies lower bond prices, which counts as net income. Put simply, the more investors worry about banks, the more profitable those banks become. As Charlie Munger once put it, "Anyone with an engineering frame of mind will look at accounting standards and want to throw up in the aisle."

Bloomberg reports Bank of America could log as much as $1 billion profit this quarter thanks to the deterioration of its own bonds. Citigroup and Morgan Stanley are also customary beneficiaries of this rule.

When accountants play this game, it's tremendously important not to take the headline earnings number seriously. You have to back out whatever gain comes from blown-out debt spreads in order to get a clear view of reality.

Unless the bank actually repurchases its own debt, there's no possible outcome where the recorded gains become permanent net income. Either the market is right and the bank is headed toward bankruptcy (unlikely), or the debt prices will recover (more likely), in which case the bank will have to reverse the gains into future losses. In either case, it's a senseless rule that harms anyone who takes it seriously.

3. Dividends
Between raising enormous amounts of capital and hoarding cash to boost liquidity, banks' balance sheets appear plenty strong today (although those are famous last words). That raises the question of when they'll resume paying regular dividends.

They may fairly soon. In this year's letter to shareholders, JPMorgan Chase CEO Jamie Dimon wrote that in order to reinstate the company's dividend back to normal levels "we would like to see three specific things happen: several months of actual improvement in U.S. employment; a significant reduction in consumer charge-offs (which improves earnings and diminishes the need for additional loan loss reserves); and more certainty around the regulatory requirements for bank capital levels."

While gains have been frail, the private sector has added jobs for five consecutive months. Check. Credit card delinquencies have been falling for six consecutive months. Check. And Congress looks like it's wrapped up negotiating details of the financial regulatory bill. Check.

Three banks I'd watch for dividend announcements are JPMorgan, Bank of America, and Wells Fargo (NYSE: WFC  ) . The other big semicommercial bank, Citigroup, can't pay any significant dividends as long as the U.S. Treasury remains a common shareholder, which, truth be told, might not be for much longer.

Your thoughts, please?
What do you think about the banking sector this quarter? Fire your views off in the comments section below.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (36)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 14, 2010, at 5:31 PM, MFRichard wrote:

    I hope JPM shows a not-so-surprising EPS or revenue because I´m short on JPM based on technical indicators, not that they matter much in this environment but time will tell.

  • Report this Comment On July 14, 2010, at 7:37 PM, SJLATTY wrote:

    The mark to market rule on deflated bank bonds, that allows a "profit" recorded by banks, should be a crime. The FASB is a co-consiritor of fraud. Bernie Maddoff should not be in jail if the Banks can lie about profits in this manner.

    The banks should go out and actually buy back thses bond before recordinf a benefit.

  • Report this Comment On July 14, 2010, at 7:59 PM, rd80 wrote:

    "Under one of the nuttiest accounting rules known to man,.."

    Yep. FASB 153 (if I recall correctly), aka mark-to-market, applied with no common sense can wreak havoc on either side of balance sheets.

  • Report this Comment On July 14, 2010, at 8:38 PM, parcheymex wrote:

    My guess is that somebody came to the banks about 24 months ago with a brilliant idea: "How

    about replacing the government role in the macro-economic cycle and offering our own rendition of

    Keynesian recovery?" For transparency reasons they really should change the accounting rules for FASB before they do this. But, what the hay

    they never new how GAAP worked in the first place.

  • Report this Comment On July 15, 2010, at 1:25 PM, cr66 wrote:

    So if the banks should not be allowed to record a mark to market gain on their issued debt, should their investors in this debt be allowed to ignore the mark to market loss this quarter?

  • Report this Comment On July 15, 2010, at 1:29 PM, TMFHousel wrote:

    "So if the banks should not be allowed to record a mark to market gain on their issued debt, should their investors in this debt be allowed to ignore the mark to market loss this quarter?"

    That's an important point. Banks should mark their debt to market, and those changes should show up in book value. For it to count in net income is what's insane. You could clear it all up by letting marks show up in book value, and reconciling the difference in net income with a footnote.

  • Report this Comment On July 15, 2010, at 3:09 PM, cr66 wrote:

    "For it to count in net income is what's insane. You could clear it all up by letting marks show up in book value"

    Is it just as insane for the investors in bank debt to take the mark to market changes through net income?

  • Report this Comment On July 16, 2010, at 12:49 PM, JSMBAPhD wrote:

    Morgan Housel says,

    "When banks look like they're in trouble, the value of their debt falls. Under one of the nuttiest accounting rules known to man, they're then allowed to count this event as net income. The idea is that a bank could theoretically buy back its own debt at a discount, hence creating value for its shareholders. (I don't get it either.)"

    This is what people who demand mark-to-market accounting rules are demanding. It's that demand that you should question.

    There are problems with mark-to-model, no question. Companies that want to cheat will come up with unrealistic models. But mark-to-market has its problems too. This is one of them.

    Proper accounting would delegate reasonable latitude to accountants, then tightly police the performance of the accountants to prevent the sort of games that were played by Enron and others intending to defraud. There are cases when mark-to-market is a better reflection. Other times, mark-to-model is appropriate.

    People who decry reasonable government and regulation--which is what policing the performance of accountants requires-- are asking to be lied to and cheat by corporations.

  • Report this Comment On July 16, 2010, at 3:52 PM, timjrollins wrote:

    I'm so happy for shareholders now that banks that have taken money from the government to pad their balance sheets are now going to turn around and give that money to shareholders. Talk about redistribution of wealth!

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1233204, ~/Articles/ArticleHandler.aspx, 9/21/2014 12:31:40 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement