How Will Banks Make Money for Real?

Back in the good old days, banks made money by lending at higher interest rates than they paid on deposits (such as savings accounts and CDs). Banks held loans instead of reselling them to investors via Wall Street, so they were careful about lending money. Otherwise, bum borrowers might stiff them and put the bank out of business. To grow revenue and profits, banks lent more money.

That was long before you and I funded the Troubled Asset Relief Program with our hard-earned tax payments.

Winning by losing less
Lately banks have been improving their profits by reducing their loan losses. Yep, you read that right. Instead of making more loans, banks are generating a big chunk of their profits from lowering the amount they expect to lose on existing loans. And a large portion of the improvement in bank earnings is due to losing less money on loans.

It is not a sustainable strategy.

Lower loan loss reserves were the primary driver of Wells Fargo's (NYSE: WFC  ) 48% year-over-year increase in first-quarter profit. Citigroup's (NYSE: C  ) first-quarter net loan loss reserves fell $2.1 billion year over year.  For perspective, Citi's net income for the quarter was $3.0 billion. Even at JPMorgan Chase (NYSE: JPM  ) , widely considered the most solid big bank, a reduction of loan loss reserves accounted for nearly half of first-quarter earnings.

For the six largest U.S. lenders -- Bank of America (NYSE: BAC  ) , JPMorgan, Citi, Wells Fargo, Goldman Sachs (NYSE: GS  ) , and Morgan Stanley (NYSE: MS  ) -- profits before taxes and "provisions" (loan losses and one-time items) slid a whopping 40% year over year in the first quarter.  Here are some specifics:

Company

Q1 2011 Change in Pre-Tax, Pre-Provision Income

B of A (55%)
Citi (48%)
JP Morgan (31%)
Wells Fargo (32%)

Source: Bloomberg News.

Revenue at the same six large lenders fell more than 13% year over year in the first quarter, driven by a decline in both lending and fees. That doesn't compare very well to the 302 S&P 500 index constituents that have reported the first quarter; as a group, these companies had revenue growth of more than 10%. Excluding financials, they increased profits 24% year over year.

Now what?
Dodd-Frank has hit banks in the fees, and I wouldn't bet on Congress backing off on that anytime soon. According to the Federal Deposit Insurance Corp., deposit-account fee income for the industry fell 21% year over year in the fourth quarter.  

With two large profit sources drying up, banks will need to turn elsewhere for revenue and earnings growth. It's no wonder banks are already loosening their lending standards in an attempt to boost new loan issuance.

Looking for loans in all the wrong places
Banks have been more willing to lend since early last year, according to a Federal Reserve survey of senior lending officers. But while loan demand has picked up modestly, it remains weak. What's more, there's a strong argument to be made that loan demand will remain weak for at least several years ... and perhaps longer.

Foolish takeaway
What's not to hate about bank stocks? Excluding "provisions" (one-time items and unsustainable loan losses), banks' pre-tax profits are tanking. Real estate continues to struggle. Dodd-Frank is hurting fee income. Consumers are strained by rising prices for gas and food and by shifting to living within their means (often forcibly, as credit gets taken away). Many companies need to reduce their debt, too.

What's a poor bank to do? For now, reductions in loan losses and loan loss reserves are big contributors to bank earnings and earnings growth. Eventually, however, that strategy runs its course. If banks can't find a new source of profits, bank earnings will start looking a lot more like the pre-provision earnings that slid 40% in the first quarter.

If you're not scared out of bank stocks, The Motley Fool recently introduced a free My Watchlist feature that can help you watch your back. You can get up-to-date news and analysis by clicking below to add companies to your watchlist now:

Fool contributor Cindy Johnson does not currently own shares of any stock in this story. No way. The Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Through a separate Rising Star portfolio, the Fool is also short Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (7)

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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 May 10, 2011, at 4:47 PM, prfssr wrote:

    So, could someone please explain to me, then, how it is that the bank execs are reaping record bonuses? Disclosure: I am long on BAC, and down more than 50% on my avg share price. A big reason I bought BAC was the 6% dividend they were paying at the time. No more. Am I a sucker for holding (and hoping)?

  • Report this Comment On May 10, 2011, at 5:35 PM, notanymore wrote:

    The author is oversimplifying bank financial statements. Find one or two things that are X% of earnings increases or declines and come to superficial conclusions that totally mislead readers. Look deeper and there are many reasons for ups and downs -- of course, many of them government regulated. Banks do want good loans and do want them on the balance sheet to produce future profits. Those with strong equity and credit cultures will prosper when the economy improves. The real question is, will the government let it happen or continue to play their silly games.

  • Report this Comment On May 10, 2011, at 10:15 PM, pete163 wrote:

    The problem is the bad loans that BofA knew these loans was bad from the start and sold them. Now with the pull backs they must pay back to Fanny and Freddie that alone could run into 10 to 30 Billions or far more. This is not a game, the tax payer are on the hook for these loans by BofA and other banks. It could be many years before it gets out from under this black cloud. Even the day traders won't go near this one.

  • Report this Comment On May 11, 2011, at 8:35 AM, notanymore wrote:

    The loans conformed to Fanny and Freddie's specs. They bought them with their eyes wide open. That the specs were mandated by government regs that encouraged lending to unqualified borrowers is conveniently forgotten. Now they are looking for blame -- America's favorite past-time.

  • Report this Comment On May 11, 2011, at 9:09 AM, DrRoberts1 wrote:

    What is the old saying? "A little knowledge is a dangerous thing." Ms. Johnson falls firmly into that camp.

    Too bad that nobody has clued her in that the "taxpayer" has actually enjoyed a profit from TARP injections that some banks (WFC and JPM come to mind as does GS) didn't even want in the first place.

    Next to prostitution, lending money is the oldest business known to man and not even one of the crappiest piles of legislation ever written by the staffs of do-gooder politicians will kill the profitibality of the so called TBTF banks.

    Does Ms. Johnson expect the housing market to remain stagnant forever? Newsflash, the most desirable tracts of land have already been developed. There is a finite supply while the population continues to grow. That is, unless Ol' Jeb manages to find a way to inhabit the White House and decides to invade Canada and/or Mexico.

    Perhaps Ms. Johnson is unaware of the fact that the majors are also heavily engaged in the managing of other people's money, for a fee of course. As they continue to retire, Baby Boomers will increasingly require those types of services.

    The very foundation of an expanding economy is a healthy banking system. It is only human nature that after being asleep during the entire fiscal disaster known as the Bush administration that the regulators would become overly zealous once the stool samples hit the fan. However, our current "genius" in the White House seems to have awakened to the fact that banks and politicians that wanna get re-elected have an incestuous relationship by definition.

    You see Ms. Johnson, deep in the swamp known as Washington D.C., money talks and bull feces walks!

  • Report this Comment On May 12, 2011, at 8:41 PM, notanymore wrote:

    Great comments, Dr. Roberts. By the way, the money paid back by the banks is not reducing the deficit. It is a cookie jar being raided by you know who.

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