In this week's Industry Focus: Financials, Gaby Lapera and John Maxfield go over the most important takeaways from the earnings reports of the nation's biggest banks -- JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), and Goldman Sachs (NYSE:GS).  

They also talk about interest rates -- what they are, just how much banks make on them, and what today's historically low rates mean for banks and consumers; why stress testing is so important and how it's affecting big banks; what long-term investors should keep in mind when looking over quarterly earnings reports in a relatively quiet sector like banking; and more. 

A full transcript follows the video. 


This podcast was recorded on Jul. 25, 2016.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You are listening to the financials edition filmed today on Monday, July 25, 2016. My name is Gaby Lapera, and joining me on the phone is one of our top analysts in the financials bureau. Hello, John Maxfield! 

John Maxfield: Hello, Gaby! I'm very happy to be with you this morning. 

Lapera: Fantastic. I'm happy that you're here with us too. Let's get right into it, folks. I think I might say that every week. I don't think I do a lot of runaround ever, except for right now. Anyway, let's get right into it. It's the end of the quarter, beginning of a new quarter. It's time to do bank earnings, because this is a financial show and that's what we do. Generally, a pretty great quarter for banks. 

Maxfield: Yeah, here's the thing. If you look at it from a fundamental perspective, not a blowout quarter, right? It's not like these banks are reporting record earnings. However, when you think about what impacts stock prices, they did actually have a really good quarter. What impacts stock prices are how a bank performs relative to analysts' expectations.

If we're just talking about the top six banks -- JPMorgan Chase, Citigroup, Wells Fargo, Bank of America and Goldman Sachs and Morgan Stanley -- five out of six of those banks turned in earnings per share that were better than what analysts expected. The one exception is Wells Fargo, which is ironic because Wells Fargo, if you look back at its historical quarterly performance, it almost never misses expectations, but it came in at $1.01 a share, which is right where analysts expected it to be. So it's not like it was a bad quarter, but not an amazing quarter. 

Lapera: I have a question for you. How do analysts come up with their expectations? 

Maxfield: That's a great question. They have models that model for differences, things that impact bank profitability, both the top and the bottom line, and then they just project those models into the future, depending on what interest rates did over a quarter, whether there were legal settlements for a particular bank in a quarter, things like that. 

Lapera: Yeah, so one of the things that analysts can do and occasionally do is modify their expectations for how they think a company will do in a middle of a quarter, based on new information, which is part of the reason that banks did so well this quarter -- because bank analysts decided that they should lower expectations, mostly because of Brexit. 

Maxfield: That's exactly right. If you go back over the past three months ... and you can see there's a lot of websites online that showed the direction of analysts' expectations and how they adjusted those ... Basically over the past three months, leading up to the end of the second quarter, analysts had consistently reduced their expectations for banks' profits on an earnings-per-share basis. The principal reason was we had the Brexit vote on June 23, where the United Kingdom was trying to determine whether or not it wanted to separate from the European Union, which we discussed on the show. Obviously, it came out the vote in favor of separating from the European Union. Even on top of that -- and we saw this in the first quarter -- you have concerns about moderating growth in China. You have concerns about what will happen to bank loan portfolios in the energy sector as a result of these low oil prices. All of these things caused the analysts to back off their earnings expectations for these banks. 

Lapera: It's one of those things where the bar was set low, but still a good job to banks for doing better than expected. 

Maxfield: Yeah, and there's one other thing to keep in mind: Interest rates are still really low right now, but banks were able to offset that -- at least a handful of the banks were able to offset that -- with just very expansive loan growths. Let's think about JPMorgan Chase as an example. JPMorgan Chase is the biggest bank in the country if you measure by assets. On a year-to-year basis, JPMorgan Chase increased its loan portfolio by a $100 billion. Now, I know when you're talking about companies this size, it's easy to lose track of how large some of these numbers are, but a $100 billion is about the size of KeyBank, which a major regional bank in the United States. The fact that it grew that much, it really was able to offset some of the other headwinds in the industry. 

Lapera: Yeah, and Wells Fargo was no slouch either, despite it being the only one that didn't beat analysts' expectations. Part of that is that Wells Fargo is such a consistent performer that I'm sure, or I'm guessing anyway, that analysts probably didn't lower their expectations as much for a Wells as they would, say, a Bank of America, but Wells Fargo was up $80 billion in loan growth year over year, which is pretty impressive. 

Maxfield: That's really impressive, and you actually bring up a really good point. When you're thinking about banks, and bank stocks in particular, there's really two things that factor into the performance of investment over time. The first is just the size, just the magnitude of your profitability. How high is return on equity? How high is your return on assets? But what also matters, in fact to an equal degree, is the consistency of your profit. You don't want a bank to have really, really high profitability, like 20% return on equities, like Bank of America and Citigroup had in 2005, 2006, and then give all of that back in a crisis or more than that. 

When you look at say Wells Fargo, U.S. Bancorp or banks like that, that have done really well over time, it is a function of both -- and let me throw M&T Bank in there, too, a regional bank based out of Buffalo, New York, which is one of the best performing banks over the past three decades. What these banks have really nailed is not only a reasonably high return on equity, but also that consistency that you talked about with Wells Fargo. 

Lapera: One day I'm going to let you and Jay Jenkins just do a show on M&T Bank. It will be just an ode to M&T. 

Maxfield: I could go on. I could talk about M&T for days. I'm a big fan of them. I know this is tangential because we're talking about earnings, but let's just talk about this now that we're here. M&T Bank is the Warren Buffett, it is the Berkshire Hathaway of banks. Since its current chairman and CEO took over in 1983, it's returned 18,000%, and that just blows not only most stocks out of the water, but a lot of banks out of the water. It comes back to just growing responsibly, generating a responsible return on equity, and just not giving that back each time the cycle turns around. 

Lapera: I knew I shouldn't have started on M&T Bank. 

Maxfield: It's your fault. 

Lapera: It is 100% my fault, I take 100% of the blame. Let's talk a little bit about interest rates, a topic that is of perennial interest to us, and one that we perennially ... I don't say we get wrong, because we always hedge our bets and say, "We don't really know what's going to happen." Interest rates were lower than expected this quarter. Again, partially Brexit is to blame, but there's just been a lot of stuff going on with interest rates in general that would affect the Fed's decisions whether or not to raise interest rates. One of those things is slow growth in China. There's that really bad jobs report in May, and also the volatility in the energy sector. Those are all contributing factors to why the Fed hasn't been raising the fed funds rate like they hinted they would start doing back in December. They did raise it once. 

Maxfield: They did raise it once, which is better than zero times, so I will give them credit for that. Here's the thing about banks: If you were going to boil down what really has a significant impact on their earnings, nothing is more important than interest rates. Even these big universal banks with both commercial banking operations and investment banking operations, on Wall Street, even they generate about half of their income from interest income. What is that? That is going out, getting deposits, paying very, very little to borrow money from depositors, and then reinvesting that money in higher interest earning assets, be it loans or some type of fixed income security. 

If interest rates are really low, that's going to decrease or hold down the amount of money that you're earning by reinvesting those deposits into higher interest earning assets, so that's why interest rates are so important. To a point you made, we are at this historically low point in interest rates. They fell during the financial crisis when the Federal Reserve was trying to free up the credit markets, and because the economy just hasn't picked up the amount of steam that the Federal Reserve wants to see at this point, it just hasn't felt comfortable raising interest rates, and that's just creating these economic headwinds for banks in terms of earnings. 

Lapera: Yeah, and if you're a consumer, this is a great time to get a loan, because your interest rates, if you have a fixed rate mortgage, are going to be super-low, but if you're a bank, it's not a great time for you, basically. For most banks, this isn't the biggest deal in the world. It's just their profits are stagnant. But for some banks, it's a lot bigger of a deal that interest rates aren't rising. 

Maxfield: Yeah, it's a big deal for everybody, but it's a really big deal for some of these banks, and let's talk about one in particular. When I think about the banking sector, the story right now is what's going to happen with Bank of America, and this is why. Bank of America, if you look at its profitability -- its return on equity -- it hasn't generated a high enough return on equity in all eight years since the crisis, to exceed its cost of capital. What does that mean? That basically means that Bank of America is out there getting money and has its shareholders' capital, and let's say it's paying 8%. That's what shareholders require of it in terms of dividends or profitability or whatever it is, but then it's only earning let's say 6% on its equity, so it's actually destroying shareholder value. One of the reasons it's destroying shareholder value is because interest rates are so low, so it's not generating enough from its asset portfolio. 

The other reason is that these regulations passed since the financial crisis have really come down hard on large universal banks. They have to hold more capital. They have to hold more liquidity on their balance sheet. They have to do all of these different things that weigh on their profitability. And Bank of America is in a situation where unlike JPMorgan Chase, it's not No. 1 on Wall Street, and unlike Wells Fargo, it's not No. 1 on Main Street, so it's playing second or third fiddle in both of its core markets, and that has impacts on its margins, because it's not getting the volume of business that its competitors are getting. Because of that, its profitability has stayed low like this. 

Its CEO has even come out to say, "Look, we are not going to be able to earn our cost of capital unless interest rates rise a little bit." Until that happens, Bank of America is going to be in this precarious situation where shareholders are going to be saying, "Look, at some point, you guys have got to be earning your cost of capital." If interest rates stay low for let's say two decades, like they have in Japan, Bank of America is going to have to make business decisions to tweak its business -- i.e., get rid of its capital markets business, trading business, that has such a big impact on its capital and liquidity requirements -- in order to appease shareholders. 

Lapera: You're 100% correct, and the interest thing, like we said, while it's not as big of a deal for say JPMorgan, it is ultimately going to affect their profitability a great deal. Banks have been pushing for awhile now for interest rates to go up, but there's really no sign from the Fed when or if that will ever happen. Speaking of which, the Fed, there's good news on stress tests for big banks. 

Maxfield: Yeah, the one thing to keep in mind is that while the banks are struggling right now from a profitability standpoint. I'm talking more about their income statements. From a balance sheet perspective, they're actually as safe as they have ever been, at least in modern memory, and that's because if you look back at the stress tests, these banks are holding just an enormous amount of capital. What the stress test does is, it makes up these hypothetical economic scenarios and then it tests to see what would happen to banks' businesses, and particularly their capital -- basically, how much money banks would lose under these economic scenarios. 

In the most recent stress tests, the results of which were released last month, the economic scenario was basically the same as the financial crisis in 2008 put together with the 2011 sovereign debt crisis in Europe. Then they looked at: "Would banks survive this economic scenario?" and "If they would, what would their capital positions be after going through this hypothetical gauntlet?"

Bank of America, Citigroup, all of the big banks, had literally tens of billions of dollars in excess capital above the regulatory minimums, even after assuming they went through this horrible economic gauntlet that the stress test presumed. To your point, Gaby, while banks are struggling right now with this stagnant revenue situation, there's just no question that they're as safe as they've been in many, many decades. 

Lapera: The other thing that I'd like to point out that the stress test tests for is having good internal controls and good risk-management practices, which you obviously need in order to have all this capital on hand. All the big banks that we talk about regularly passed -- JPMorgan, Wells Fargo, Bank of America. There's one other bank that failed, and it was on internal controls. It wasn't on capital and liquidity, but just on internal controls and governance stuff. It was Banco Santander or, if you're my mother, Banco Santander. You're welcome, I'm so sorry, I was pronouncing it with my horrible American accent the last show. There was one other bank, I can't remember, but neither of them failed because they lacked capital or liquidity; it was because of internal controls. Everyone else passed with flying colors on all fronts. 

Maxfield: Yeah, that other bank was Deutsche Bank

Lapera: Deutsche Bank, that makes sense. 

Maxfield: Yeah, it's like European banks are just in a world of hurt right now, given everything that's going on. 

Lapera: Deutsche Bank has been in a world of hurt partially of its own doing for awhile now. Pre-Brexit, it was not a pretty picture. Maybe another show, we'll talk about Deutsche Bank. 

Maxfield: Yeah, you're exactly right. In fairness to Deutsche Bank, it's not as bad as the Italian banks in terms of my understanding of what's going on over there. It's trading for a quarter of book value, in or around there. If you think a quarter of book value, that's like September 2008, to put it in perspective.

Lapera: For listeners who don't know, book value is basically how much the business is worth. If you sold everything that was in Deutsche Bank, you would get more than what you're actually paying for the stock. It's crazy. 

Maxfield: Like four times as much. 

Lapera: You'd get four times as much. 

Maxfield: That's crazy, yeah. You bring up actually a really good point about a stress test: They don't just test that quantitative element, like how much capital; they also test that qualitative element. Most banks that have gotten into trouble in the past, it really isn't that quantitative element. But just ask the question: Are these banks' capital and risk models sophisticated enough in this day and age to determine what would happen in that type of economic scenario? 

Lapera: Yeah, and good job for the Fed for making it that way. Just back to bank earnings, we hit some of the main things about stuff that drives bank earnings -- so loan growth, interest rates -- and we talked a little bit about what was going on in the world financially that could affect it. So why don't we talk a little bit about capital markets, because a lot of these big universal banks are seen as market makers. 

Maxfield: Right, so if you look at these universal banks, there's two components of them. There's the depository and lending side of their operations, which is what your typical person thinks about when they think about a bank. But then there's also that Wall Street side of the business -- that's taking companies public, that's issuing bonds for companies, that's acting as market makers in the trading markets. Those are known as capital markets business. What we saw in the first quarter was that because of all the volatility in the markets, caused by the European stuff, the concerns about China, the concerns in the energy market -- volatility in the capital market is really high, and when volatility is really high in the capital markets, clients of these banks that need to trade securities step back from the market because there's just no reason to get in there when prices are going all over the place. 

When they step back from the capital markets, these banks that act as market makers earn less in commissions. That drove down sales and trading revenue by double digits in the first quarter, and there was a concern that that would be the same situation the second quarter, but it's actually the exact opposite. Almost all of the banks reported double-digit year-over-year increases in their capital markets businesses, which in addition to that loan growth, really helped them in terms of trying to beat analysts' expectations. 

Lapera: Yeah, that's fantastic. I think that we've just about covered everything. The only other thing that we haven't covered is the energy sector. It's still weak right now, and the banks that have large portfolios that rely on energy are still shoring up their reserves, but it doesn't seem like it's ... I don't know, I don't think it will go on forever. 

Maxfield: Yeah, all you have to do is just look at a chart of oil prices. They bottomed out below $30 a barrel in the first quarter, but they've since improved. I don't know exactly where they're at today, but on Friday they were at $44 or $45 a barrel, so a lot of banks had been modeling, when they're setting aside loan-loss reserves for $30 a barrel oil. That's what they're modeling for in the first quarter. Now that the oil is way above that -- it's still half as much as it was a couple of years ago -- but the fact that it's above that $30 a barrel benchmark means that it's heading in the right directions for banks. 

I think it's still fair to expect higher losses from banks in their energy portfolios, particularly this year, because the way that their energy customers work is that they hedge their own positions in the oil and gas markets, but you can only hedge out two years, so even the maximum hedge starting in 2014, which is when oil prices declined, extends into this year, so this is really where the rubber's going to meet the road in terms of the oil market's impact on banks. 

Lapera: Just in case any of our listeners are wondering, right now, Monday, July 25 at 12:58 p.m. Eastern time, the price of a barrel of crude oil is $44.21. 

Maxfield: There you go, so better than $30. 

Lapera: Better than $30, which is what they were originally modeling for. Overall, it's a good quarter. It's not the best quarter of all time, but you know, they had a quarter. 

Maxfield: They had a quarter. Yeah, it wasn't anything huge to write home about, either for good reasons or for the bad reasons. 

Lapera: Yeah, and one of the things that I think we always say on these earnings shows -- I don't know how people haven't gotten sick of us yet just repeating ourselves -- is that it's a short term thing, looking at quarterly earnings. Yes, they're important to look at. If something super-drastic happens, it's a good time to reevaluate your thesis and evaluate your portfolio, but if you're a long term holder of a stock, then there's not much to worry about right now. 

Maxfield: Yeah, not much to worry about, and really the value, what I have found in terms of analyzing quarterly earnings and in terms of being an investor in banks and other companies, is where I really get value is each of these companies when they report earnings holds a conference call after they report earnings to walk investors and analysts through their performance in a quarter, and also to answer analysts' questions. Where I really see value from an investor's perspective, is listening to what the CEO and the CFO say in that call, trying to get a sense for what analysts are asking, and get a sense for how the executives are responding to those analysts' questions. That really is where I find the value in terms of quarterly earnings. 

Lapera: Yeah, quarterly earnings, it's just for me an overall good time to have a check-in, just see what's going on, but it's never really a time to panic unless someone says like, "Oh, J/K, I actually cheated on all my federal stress tests and I don't have any money." Until that happens, quarterly earnings are never a time of huge stress for me. If you guys have any questions, definitely write in. We would love to do another mailbag episode soon, so the more questions the better. Otherwise, we're going to make up questions and they're going to sound like: Austin M. from Alexandria, Virginia, would like to know what banks are. Austin Morgan is our fabulous producer, just in case you're wondering. Thank you very much for joining us, John.

Maxfield: Thank you very much for having me, Gaby. It's always a pleasure.

Lapera: Fantastic. We'll talk to you in a couple of weeks. As usual, people on the program may have interest in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy yourself stocks based solely on what you hear. Contact us at or by tweeting us @MFindustryfocus. Thank you to Austin Morgan/Austin M., today's totally awesome producer, and thank you to you all for joining us. Everyone have a great week!  

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.