1 Reason Everyone Was Wrong About These Banks' Earnings

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If there was anything curious about the results from Wells Fargo  (NYSE: WFC  ) and JPMorgan Chase  (NYSE: JPM  ) today, it's that the results didn't line up with the general "ugh" feeling that investors seem to have about the banking environment right now.

Not that investors are wrong -- it's not a stellar environment for banks. And not that the earnings reports were knock-the-cover-off good. But they were fine, and that was good enough to top analyst expectations in both cases.

Still on the mend
If you're looking for a reason that both banks were able to tread water, one answer is that they're still shaking off the after-effects of the financial crisis. That's right: Six years later, that's still true. In fact, it's probably more true today than it was last year.

Pre-release coverage of JPMorgan's earnings focused on the bite that legal costs would take out of earnings. Go back a year, though, and you find $1.2 billion in legal costs for the fourth quarter of 2012. So $800 million is certainly a hit to 2013's final quarter, but it's actually a year-over-year improvement.

We don't hear as much about Wells Fargo's legal costs, but in reviewing Q4 results from its community banking segment results, the company noted: "Noninterest expense declined $960 million ... from a year ago largely due to costs in 2012 associated with the OCC's [Office of the Comptroller of the Currency] Independent Foreclosure Review settlement."

Beyond the lawyers
It's not just settlement activity. Provisions for loan losses plummeted for both banks versus last year. When the sky was falling on the housing market, the banks built up big cushions. Now, as the picture improves, they're reversing some of that safety blanket.

Combine the drop in legal costs and loan-loss provisions, and you get to some serious numbers. For JPMorgan we're talking about something in the neighborhood of $1 billion in pre-tax income for the last quarter.

Sustaining profits
The concern, of course, is the sustainability of these earnings supports. There's little reason to believe that the wave of crisis-era settlements is completely over. But there will come a time when the banks can say that more or less with a straight face. That will make the unadjusted cost structure of the biggest banks look much better. This isn't a route to indefinite profit growth, but it's an improvement that -- assuming lawsuit-worthy practices have been cleaned up -- will stick.

The provisions aren't quite as straightforward. Setting aside reserves against loan losses is business as usual for a bank. And by basically any measure, the level of provisions in the recent quarters has been below a long-term sustainable level. In other words, provisions will come up. Eventually.

However, between now and eventually, there may still be considerable reserves that can be released. That means that -- especially as we watch a continued improvement in the economy and housing market -- we may not see provisions suddenly spike back up to a "normal" level. And by the time they do make that climb, improved conditions for banks may bring the top-line improvements that investors are missing right now.

The flip side of awful
Even as the stocks of the big banks have been on a tear, the commentary around the banks has continued to be conservative. Call it concern over court cases. Or new regulations. Or fixed-income trading. Or the low interest rates. Whatever. The bottom line is that the dour view of the sector continues to set up the banks to outperform on the basis of simply not being as bad as the prior year. Or even not being all that much worse than the prior year.

When do you worry, then? Easy -- when things start actually looking good.

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