A Bear of an Earnings Season for Big Banks

On this Financials edition of the Motley Fool's Industry Focus podcast, host Gaby Lapera and analyst Jay Jenkins try to make sense of the good, the bad, and the downright ugly first-quarter numbers at the nation's largest banks. JPMorgan (JPM 0.15%), Bank of America (BAC -1.07%), Wells Fargo (WFC -1.11%), and Citigroup (C -1.09%), each came through with earnings reports ahead of Wall Street expectations, sending their beleaguered stock prices higher. However, digging into the numbers a layer deeper reveals a lot of problems creeping onto the income statements of these megasized institutions. Tune in to find out exactly how bad the first quarter was and what it means for these stocks for the rest of the year.

A full transcript follows the video.

This podcast was recorded on April 18, 2016. 

Gaby Lapera: Living wills for banks. This is Industry Focus, financials edition.

Hello, everyone. Welcome to Industry Focus, financials edition. Today is April 18th, 2016. My name is Gaby Lapera. Joining me on the phone is analyst Jay Jenkins. Hey, how are you?

Jay Jenkins: Hey, Gaby. Glad to be here.

Lapera: Awesome. This is totally random, but my mother wanted to let you know that she thinks that you have a lovely voice.

Jenkins: That's very sweet of her.

Lapera: Yeah, she told me last night. She was, like, Gaby you should really tell Jay Jenkins he has a nice voice. I was, like, "OK I can do that for you." Anyway, before we get started into the meat of our episode, I wanted to thank Alex Grayson, Goud from West Kelowna, Canada, Michelle, Balal Rasool, and Mohammed Albensaleh for writing in about last week's episode about writing. We love getting mail, especially feedback on what you think about the shows. Speaking of which, we are gearing up for another mailbag episode. Send in those questions to [email protected] or tweet us @MFindustryfocus.

Today's episode, we are going to talk a little bit about bank earnings and a little bit about living wills. I wanted to start with the living wills, because this is a really interesting concept. The living wills are something that the Federal Government came up with for the big mega banks. The people who got into the most trouble... minus the small banks that completely went under, but the people who got into the most trouble during the last financial crisis, they want those banks to put together an action plan for what they would do if another financial crisis happened.

Jenkins: That's right, it's really these big systemically important banks that they are most worried about, Gaby. The idea is that if something were to happen again, like what happened in '08 and '09 or perhaps even worse, the government wants to have an idea of what we're going to do. What is the contingency plan so that the taxpayers don't have to bail out a Bear Sterns or Washington Mutual or any banks that survived -- JPMorgan, Wells Fargo, Bank of America, whoever. All of these huge banks with trillion dollars of assets that could really move the needle to the entire global economy if they failed. What are we going to do if it hits the fan again? How are we going to deal with all of these assets? The derivative books, all these things are so complex. Everything is so interrelated around the world. We need to get in front of this. That is the whole idea.

Lapera: Right, this isn't a new concept for the federal government, right? We have Dodd-Frank and on a more international scale we have Basel III regulations. This is something that people have been thinking about and this is just one more facet of that. Also, the banks that are going to be included in that are going to be JPMorgan, Wells Fargo, Citigroup, Bank of America and... who else? Is USB on there?

Jenkins: You know, I'm not a 100% sure. I forget the exact threshold, Morgan Stanley was included, I think Goldman was also included. It really boils down to these large, systemically important banks. As I said, if these banks get in trouble, all of us are in trouble. As opposed to a local community bank, where their assets might be a few hundred million, which is a lot of money and assets, but it's not going to tip the scale on the U.S. economy and certainly not the global economy.

Lapera: Definitely, the big news this week is that the eight major mega banks that everyone has their eyes on, almost all of them failed.

Jenkins: Yeah, it was pretty ugly. The exact words by the FDIC and the Federal Reserve was that these banks were "not credible." That's about as close to a punch in the face as I think you can get, in the banking world.

Lapera: The only bank that kind of scraped by was Citigroup. They didn't do great, either. When I say the scraped by, they got a D+. Technically, you didn't fail, but it's not great, either.

Jenkins: The way it works is the FDIC and the Federal Reserve each get a vote, there are two governing bodies that give a pass/fail. Citigroup got a pass from one, but a fail from the other. That is the squeaking by part, everyone else... I'm sorry, I got that incorrect. Citigroup is the only one that passed from both. Goldman and Morgan Stanley got a pass from one but not the other. Then everyone else failed straight across the board. It was a pretty poor showing by our mega banks.

Lapera: Yeah, I believe the FDIC and Federal Reserve told Citigroup that while they passed, it was just barely. It was not a great plan, regardless. I don't know if there are any teachers out there, but sometimes when you're grading you get to these essays that aren't that great, but they are so much better than the ones you read before that you're like fine, I have to give someone a pass.

Jenkins: Someone has to pass, you get that feeling.

Lapera: I wonder if that's what happened with Citigroup.

Jenkins: There is really no telling, I was reading in the news and trying to dive a little more deeply than just the headlines you'd see on the news or online. A lot of things that these banks were criticized for, some of them you just shake your head and how do you guys not have a handle on this? Wells Fargo, for example, was criticized for their legal structure and some of their governance policies and procedures. They also found material errors, where they just got the math wrong. It really brought into question quality control and accuracy. You almost got the feeling that the Federal Reserve was like: Wells are you even taking this seriously?

On the flipside, JPMorgan is so complex, I don't know how anyone could wrap their head around the whole bank. Their criticism revolved around how they deal with moving money overseas. Their investment banking side is so complex and worldwide. They have money moving all the time, everywhere. Apparently, the protocol in dealing with that in a crisis or an illiquidity crunch were not up to snuff. Of course, their derivative book, which is the largest in the world by far, it's like the largest plate of spaghetti in the world. How do you even begin to figure out what is going on in that big pile of contracts? The Fed was not OK with their plan for dealing with all that complexity and unwinding it in a reasonable way.

The errors were really across the board, from the simple stuff, like what we saw with Wells to JPMorgan's overwhelming complexity. Banks, they just failed across all aspects of what we are trying to accomplish here.

Lapera: I guess the first question investors or listeners would ask themselves is, is this something to worry about?

Jenkins: To me, there is two angles on this. Wells Fargo is a good example of this, if they're not taking this seriously and making material errors in this, where else are they making material errors? For an investor, that's got to be kind of concerning. It was like several years ago when Bank of America miscalculated their capital. The calculation was only off by a basis point, or three, very small percentage.

Lapera: Still.

Jenkins: Part of the question is what are they doing? Do they really understand where everything is and how it's flowing? Are their spreadsheets correct? Is their accounting really correct? On the one hand, that is somewhat troublesome, but I think in the grander scheme of things, these living wills are important, but for investors, I think it's just a check box that the regulators are going to make the banks do. I don't think that it has any indication that the bank's underlying businesses are going to do, better, worse or otherwise. Particularly, I keep coming back to JPMorgan and Wells Fargo, but during the financial crisis, arguably they went through the whole crisis better than any other bank, perhaps in the world. These banks are really well capitalized, really well managed, they've great liquidity. They really seized the opportunity and were able to absorb a lot of new assets over that period of time. From that perspective, you've got to have faith in this fortress balance sheet concept. These banks will probably be OK.

Lapera: It's not just that, but with the living wills it would be great if they had a plan just in case there was another financial crisis and they did fail. You have to understand with all of the beefed up regulations that the Federal Government has given these banks, the likelihood of them failing is increasingly less every year.

Jenkins: I totally agree. The new liquidity of the requirements to me, were the biggest step toward doing that. Then the capital requirements on top of that. You have this nice new cushion of cash, so if the markets go liquid, they still will be OK. They still will be able to pay bills and keep the economy moving. If they do start mounting losses, they have all this new capital, based on these really high quality assets. To me, it doesn't matter. Yes, it is an important step, yes it's important for them to be thinking about it. Is it going to make the stock move higher or lower over the next 12 or 18 months? I very seriously doubt it.

Lapera: Yeah, not unless they end up failing this eight times in a row.

Jenkins: Correct.

Lapera: I don't really know why any of them would.

Jenkins: Correct, that would be a big time negative from a management perspective. Which for a value investor, which is what we preach here, it starts with management. These are the folks that are making the decisions that run the company. So if they can't get it together to get this right, between now and I guess October is when they have to fix all these problems, that would be bad. I imagine some people would get fired for that.

Lapera: Speaking of how the banks are doing and how their stock prices would be doing, do you want to talk about earnings? All the mega banks have reported.

Jenkins: Absolutely, it's earnings season. Last week all of the four mega banks in the U.S. reported. It was kind of a case, Gaby of good news but bad news, but also kind of mucky what are we really doing here? It's kind of a muddy situation I think. On the positive, the good: All four mega banks beat earnings expectations. Citigroup beat by $0.07, JPMorgan beat by $0.09, Bank of America by $0.01, and Wells Fargo by $0.02. That's really good news. It's better to beat than to come up short.

Lapera: Unfortunately...

Jenkins: Another good news was that the stocks were up.

Lapera: Oh yeah, that is great news. Yay, for all of them, especially Bank of America, I believe you can make it, buddy!

Jenkins: The past five days, all four of the mega banks have outpaced the S&P 500. Wells Fargo up 3.3% as we're recording this, the other mega banks are up 7 to 9% almost 10% over the week. That's a pretty healthy jump, that's awesome, that's great for investors. We want the stock chart to go from the lower left to the upper right, and that's what they've been doing this week.

Lapera: Right, but unfortunately the reason that we have good news to begin with, is because analysts thought the banks were going to do worse than they did. That's the only reason they did OK to begin with, is because analysts were like "you guys are going to have a terrible quarter."

Jenkins: That's exactly the truth, they did less bad. It's really when you dig into the numbers, pretty ugly. Particularly from a short term perspective. For example, profit change from the fourth quarter to the first quarter; we're down at every single mega bank. Ranging from $400 million all the way to $1.3 billion down at Citigroup, which is a pretty sharp decline. That's not good. Revenues were down: pressure, top line and bottom line. Now, I would want to point out... let me preface this by saying that trading revenues were a big driver. We'll dig more into that in a second.

We should have anticipated this, and the markets did anticipate this, with the lower expectations, because if you remember the bloodbath of the markets started the year. It was the worst start, I forget exactly how long, but the first five trading days were just absolutely terrible. January was horrible, everybody was freaking out. If you look at the chart now, I think it is important for long-term investors to remember that the S&P is basically back to where we were in December. We had all that stress and drama, and we're OK, we're back to where we were.

Lapera: Yeah, for nothing really. All that stress and drama for nothing.

Jenkins: Keep long-term and you'll add years to your life.

Lapera: Yeah. The other thing to keep in mind with these earnings is that none of it was unexpected. You mentioned trading revenues and all of the banks came out before earnings and said, "Listen, trading revenues are down and that's going to drag down our profit."

Jenkins: That's exactly right.

Lapera: All of them said that, like you said, a lot of that is related to... what did you call it? The bloodbath of January?

Jenkins: It was gnarly, for sure. To the trading revenue, I have some statistics here to paint the picture. JPMorgan, we've already described them of having the big derivative book and trading operation; 66% of their overall, topline, net revenue decline was driven by a drop in trading revenue. 43% at Bank of America, 31% at Citigroup. Wells Fargo doesn't really mess with the trading business very much, so their trading revenue was actually down $200 million, which is a 50% decline. For them, that hardly moves the needle on their $22 billion in top-line revenue.

Lapera: Right, Wells Fargo is more of a retail bank, for our listeners; retail banks specialize in loans and more traditional bank products, as opposed to trading, which all the other ones have a hand in.

Jenkins: Exactly. You think of Wells Fargo as a very, very large community bank. They do home loans, they manage money for a brokerage account and retirement accounts, that sort of thing. Commercial loans and that's kind of it. It's probably more complex than that, but fundamentally it's pretty simple.

Lapera: If you are looking for an easy mega bank to start your analysis on, Wells Fargo is definitely it. Because with JPMorgan, if you look at some of those income statements and balance sheets, you're like: "I have no idea where all of this money is coming from or where it's going." It's very confusing, I don't even know what half of these business segments are. Wells Fargo is definitely... it's a small bank scaled up, just the numbers are a lot bigger.

Jenkins: Totally agree. I would even add to that point, that's some good advice. Look at U.S. Bancorp as well, that's a good bank that is similar to Wells Fargo and how they do business. I'd say Citigroup is another one to avoid; their income statement is chaos. It's extremely hard to figure out Citigroup, just because their operations are so vast and so worldwide.

Lapera: Citigroup is a very interesting bank to me.

Jenkins: Citigroup is a challenge, I'd say.

Lapera: I feel like I'm turning into my mother as I age, because that is exactly what she says about boys that she doesn't like that I bring home. "They're very interesting, Gaby." Another reason that revenue is down with these banks is because of the energy crisis. When I say energy crisis, I mean that oil is really low, not that we are hurting for oil, it's not the 70s.

Jenkins: That's right, everyone is talking about energy this earning season. Ripple effects are being felt, almost through every and any industry. Banking is on the bleeding edge of that, on the outside of the oil and gas companies themselves. To your point, you called it a crisis and let's temper that, I have a data point here to kind of push that point. Goldman Sachs recently put out a report estimating that the banking industry had total lending credit exposure in the energy industry of about 2.5% of total assets. That's a lot when you're talking trillions and trillions of dollars, 2.5% is a huge amount in raw dollar terms.

However, in 2007 almost 33% of the banking industry assets were composed of those mortgage assets that sailed so quickly and caused a financial crisis. 10-15 times more than what we see in the energy industry today. It's bad, but it's nothing like it was in 2007, even if energy stays at this level, indefinitely, the probability of this turning into something crisis-level is pretty low, in terms of the banking industry.

Lapera: Yeah, again, it's not stuff to freak out about now. Especially these big mega banks, these are the guys that are insulated from oil problems. It's the really small oil patch banks that are kind of new, that don't have a history, that don't really know how to ride the ebbs and flows of the oil industry. Those are going to be the ones that are going to be in a lot more trouble. Or the community banks that are reliant on those oil communities. Those are the guys that are going to be in trouble, not the big mega banks.

Jenkins: Absolutely, it's the concentrations that get in trouble. If you're allowed too much on one type of loan, then that type of loan goes bad in mass, those are the banks that are really going to get in trouble. Washington Mutual, Bear Sterns, these are basically mortgage securities and balance sheets. All mortgage securities, and that's the reason they failed and Wells didn't and JPMorgan didn't. Anyway, to the point today, these earnings, real quick, I just wanted to point out the impact that these energy loans are having today is significant. We talk long term, this is probably not the end of the world, but it is having a big impact.

Banks put aside cash every quarter for things that they think might go wrong. They call it their provision for loans and lease losses. They take that cash and they put it on a pool on their balance sheet, called their "credit loss reserves." The impact of this is, if they think loans are going bad, or as loans begin to go bad, it hurts the income statement, because banks have to take that cash as an expense in their provision and move it to the balance sheet, as a rainy day fund. We saw all the mega banks and most regional banks are putting aside more money this quarter because of those energy loans. Bank of America put aside almost a billion dollars, $997 million. Wells Fargo increased its loan loss reserves for the first time since 2009; adding $200 million. Again, this is not peanuts -- this is a lot of money. JPMorgan, nearly doubled its provision, increasing it 88%.

This is having a material impact on earnings, even if we don't think it's going to be a long-term, major problem. It definitely is a problem.

Lapera: Yeah, for our listeners, part of the reason that it is a big deal that they are putting aside more money, is that is money that they could otherwise use in investing or giving out loans. They are sacrificing the ability to make money, temporarily, just to hedge their bets against oil going completely belly up.

Jenkins: You're exactly right. There is a flip side; if oil prices rebound more quickly than people expect and things get better, that money in the rainy day fund can get reversed, essentially, and I could come back to the income statement as a positive instead of as an expense, or a negative. Down the road, this could be a boost to earnings as opposed to today, it is a headwind.

Lapera: The final factor that has been hitting bank earnings is that, although we don't know what is exactly going to happen with the interest rate, I think we've talked about on the show before, interest rates are like looking into a crystal ball. It does look like the Fed is going to very, very slowly raise them. That's not really going to help boost banks' income. Until they start raising them to a higher levels, banks aren't going to make as much money as they could.

Jenkins: That's exactly right. That's the trillion dollar question, how quickly will they raise them? There's a million factors that go into that, it's impossible to predict. I won't even waste your time with a guess. It could by a year, it can be six months, it can be two years. There's really no way to know. However, knowing that, and most people think the rise in rates will be slow, as an investor, you should really be looking for banks that aren't just sitting back waiting for rates to rise to solve their earnings problem. You want to find banks that are out there, hustling, finding new ways to make money, new ways to attract customers. Who are the banks that are just attacking the problem head on, and not just sitting back and waiting. Those are the banks that I think you'll see this earning season and as we're moving forward quarter by quarter, those are the banks that will continue to out preform. Those are the ones that will have premium valuations, they are the ones that will increase dividends over time. Everyone else will be just sitting back, waiting, stagnant. You don't want to go sideways, you want to go up.

Lapera: The way you look at this if you're looking at 10-K's or 10-Q's, is to look at the split between interest income and non-interest income, and figure out how banks are making their non-interest income. That's where they're making money when interest rates are low. That's one of the best ways for them to make money when interest rates are low.

We are just about out of time, I want to wrap up the show. I have a couple of announcements I was told to give you all. We will soon be available on Spotify in some countries, but definitely the United States. Also, our new mobile app is coming out on Friday, April 22nd. Just go to app.fool.com on your iPad or iPhone to download it. You'll be able to read articles and more importantly, listen to podcasts, which is very exciting because then you get to listen to me all the time.

As usual, people on the program may have interest in the stocks mentioned, and The Motley Fool may have formal recommendations for or against the stocks. Please don't buy or sell based solely on what you hear. Email us at [email protected] or tweet us @MFindustryfocus with any of those mailbag questions. Thanks very much for joining us and you all have a good day!