Industry Focus: Financials host Michael Douglass and contributor Matt Frankel take a close look at the recently released fourth-quarter big bank earnings. In addition to the individual banks' results, here's what investors need to know about tax reform, rising interest rates, and other industrywide catalysts.

A full transcript follows the video.

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This video was recorded on Jan. 22, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, January 22nd, and we're talking big bank earnings and investing today. I'm your host, Michael Douglass, and I'm joined by Matt Frankel as per usual. Matt, welcome back to the show!

Matt Frankel: Thanks! Always good to be here! I'm ready to get back into the swing of things in the new year.

Douglass: I know, I was about to say, it's only our second show so far in 2018, because the Monday holidays have really gotten in the way. If you missed us, dear listeners, we missed you too, and we're glad to be back. 

Before we dive into big bank earnings, which is the big news of the day, it wouldn't be a Financials episode, let's face it, if I didn't offer you something to email in about. Today's episode is best listened to with a broader perspective on big banks. I highly recommend listening to our October 23rd episode, in which we covered Q3 big bank earnings, for perspective. We'll be referencing that some during this episode, but it's a good background if you've forgotten where things are standing with the big banks. We also discussed how to really understand big banks and how to compare them in that episode, which is something we're just not really going to cover as much this time around. I'm assuming that you've heard that episode or you have that background. So, all that is to say, you can find the October 23rd episode in whatever podcast app you're listening to us on. Just scroll back. But, if you prefer to read a transcript of that episode, drop me a note at [email protected] and I'll be happy to send that along. It might be a little faster than listening to the podcast, and you won't have to hear quite as many of my vocalized pauses.

So, with that in mind, let's talk about big bank earnings. That's Morgan Stanley (MS -1.31%) and Goldman Sachs (GS -1.72%), the investment banks; Wells Fargo (WFC -1.46%) and USB (USB 1.07%), the commercial banks; and Bank of America (BAC -1.25%), Citigroup (C -1.04%), and JPMorgan (JPM -1.19%), the universal banks. But before we get into specifics, let's talk general trends. The headline thing that I think everyone was talking about was tax reform. One-time hits but long-term benefits to the banks. That one-time hit is because they had to write down some expected tax benefits.

Frankel: Yeah. I actually wrote an article about a week before bank earnings came out that they would pretty much universally look worse than you thought, just because of these big charges they were taking. And some took a lot bigger charges than others. The reason for this is, a lot of banks, on their balance sheet, carry what are called deferred tax assets. In, say, Citigroup's case, this stems from losses that they incurred from the financial crisis fallout. Theirs is something to the tune of $100 billion. So, these are pretty valuable things. The way to think about it is, if you're assuming a 35% corporate tax rate, and all of the sudden the tax rate drops to 21% like it just did, these deferred tax assets lose 14% of their value. So, banks had to take a one-time write down on these assets. You can't continue to carry them on your balance sheet and call them a value that they're not. But, these were generally in the $2-4 billion range for the big banks. Citigroup's was a big exception, they took a $22 billion hit that actually worked out to over $8 a share. But, Morgan Stanley took $1 billion, JP Morgan took $2.4 billion, Bank of America took $2.9 billion. Goldman actually took a $4.4 billion hit for another reason. Most of theirs came from their repatriation, which also hit a few of the banks. That's when, in the new tax bill, they passed the thing where, all the money that you're holding overseas is deemed to be repatriated at a 15.5% tax rate, and Goldman had a lot of money sitting overseas.

Douglass: Right. You see this also hitting some of big tech giants as well, notably Apple. But, first off, of course, when you hear "big tax write down," that sounds not great. Obviously, wiping $22 billion out of net income isn't exactly awesome. But when you think about it, this is a great problem to have. "Oh, no, our deferred tax assets aren't worth as much because our tax rates have gone down!" Long-term, that's going to be a big benefit for the banks. I think that's the other piece that they really highlighted. All of them were saying, "This is going to make operating more profitable over the long term.

Frankel: Right. Generally, the banks run at effective tax rates of between 29-31%. So, a 21% corporate tax rate is definitely going to benefit them over the long run. You have to factor in state taxes into that. But most of them are projecting 2018 effective tax rates in the low 20s. This will definitely be a big help over the long run. It would be like me saying, "OK, Michael, you pay me $2,000, but your taxes are $1,000 per year for forever."

Douglass: Right. I would take that deal.

Frankel: Right. And the banks are happy to do it as well.

Douglass: Right. I think this also highlights another important thing to think about, which is, it's so important to look beyond headline numbers, and it really highlights for me why investing in numbers, looking at revenue growth, earnings-per-share growth or something like that, without real context, can be incredibly dangerous. Citigroup reported a net loss of $6.2 billion last year because of its $22 billion tax charge. But if you net out that $22 billion tax charge, Citigroup actually saw its bottom line in 2017 grow by 6% compared to 2016. And so, if there's one key thing I think everyone should learn from this, if you don't know it already, it's that context matters. If you tend to invest based on metrics, it's really important to get the backstory to understand what feeds into those metrics, because frankly, stuff like this happens, and it can skew the picture in ways that could have you making a big mistake if you don't really understand all the nuance around that.

With that in mind, let's head on over to trading revenue, which was another one of the big headline things that we saw across the banks, that trading revenue was down substantially. This was something we highlighted last quarter, in large part because of low volatility. Frankly, when the market just keeps going up, it's a lot more difficult to make that kind of money in trading revenue.

Frankel: Right. This is Goldman Sachs' and Morgan Stanley's bread and butter, and the kind of really dropped the ball on this quarter, for lack of a better term. Fixed income especially is a really tough environment when volatility stays low like it has. Goldman's fixed income trading revenue was down by 50% year over year, so, half of what it was before. Morgan Stanley's was down 46%. Surprisingly, some of the universal banks didn't do too bad. Bank of America's was only down 13%. Its equity trading revenue didn't drop at all. I think JPMorgan was somewhere in the middle in the 20s, as far as their trading revenue drop. But, this is definitely something to keep an eye on. If the market happens to drop and volatility picks up, this is kind of a safety net for some of these banks, because Goldman's trading revenue is going to go through the roof if the market starts to plunge or gets pretty volatile. This is definitely an area to keep an eye on.

Douglass: Yes. It's interesting, when things are going well, there are parts of the banks that do well; and when things are going poorly, there are parts of the banks that also do well, and of course, those are balanced out by parts that are doing poorly. In this case, it's definitely a big hit to, particularly, Goldman Sachs.

Let's talk a little bit about margin expansion, as well. If you spend time on the internet, and if the marketers out there think that you're interested in certificates of deposits and savings rates and stuff -- I'm one of those people that they very much think are interested in this, and it's because I am -- you've probably seen an uptick in the advertised CD rates and savings account rates that are making their way around the internet. And that's because interest rates have increased. The Fed has bumped them and plan to continue bumping them. Also, if you have a credit card, you probably noticed that the interest rate charges that you could theoretically incur if you don't pay off your balance each month have also increased, and that's, again, because of interest rates increasing. Keep in mind, when interest rates increase, banks usually increase their payouts, how much they're going to pay out to try and attract your deposits, particularly in a CD or a savings account or a money market account. On the flip side, they're also going to charge more for loans. And their margins expand when they're able to charge more, when they're able to grow the amount that they're charging for loans by more than the amount that they're paying out extra for CDs and savings accounts. That's very much what's happening across the board.

Frankel: Yeah. We've seen this in most of the big banks. It's not a completely predictable relationship, but generally speaking, the banks are seeing about 10 basis points of margin expansion as opposed to this time last year. But, when you're talking about banks with $1 trillion in loans --

Douglass: [laughs] That's a lot of money.

Frankel: That's a lot of money. So, this is definitely a positive catalyst. And looking forward, the Fed is expected to raise rates at least three times this year. Now we're hearing chatter of maybe four, and another couple times in 2019, maybe a couple of more times in 2020. We're still in the early stages of the rate hike cycle. So, this could definitely be a trend that we're seeing over the next few years, that margins will continue to expand.

Douglass: Yes. Investors in banks with significant loan operations who have been craving seeing some kind of growth for a long time, probably going to see some significant rewards over these next couple of years, at least in terms of, at least a moral victory, like, "I knew this was going to happen eventually." Now, of course, whether stock prices fall, that's an open question. How much of that is already baked into these stock prices is perhaps another conversation for another day. But definitely, the underlying metrics are starting to look increasingly good. And one other thing that I'll highlight -- lower efficiency rates. Bank of America and Citigroup, I noticed, particularly, had their efficiency rates down for 2017. Citigroup is down to 58%, which is pretty unheard of, given that it's historically been a comparatively inefficient bank. For background, remember that an efficiency ratio, 60% or below is considered very good. So, really, really good news to see for those two.

Frankel: Yeah, definitely. What I would like to add with efficiency ratios is, take the fourth quarter efficiency ratios with a big grain of salt, just because of these tax charges. For example, U.S. Bank had a 70% efficiency ratio. We all know, anyone who follows that company knows, U.S. Bank does not operate at a 70% efficiency rate.

Douglass: [laughs] Right. That's why I highlighted year-long, for exactly that reason, because most of them crept up in the fourth quarter.

Frankel: In general, take fourth quarter metrics you're reading in U.S. Bank earnings with a grain of salt.

Douglass: [laughs] Right, I think that's very fair. Cool. OK, let's talk about some specifics with each bank, which we've already delved into just a little bit with the overall trends. But, I don't know, I really enjoy this part, because it's a chance to really understand how each one is performing. Shall we start with the universal banks?

Frankel: Sure.

Douglass: Awesome. Citigroup. They saw their net credit losses grow by 7% year-over-year. For me, this is always a wee bit of a concern, because things may look good now, but it's a different ballgame when the credit cycle turns. Of course, frankly, when you look at what the Fed is guiding in terms of additional interest rate hikes, it looks like the good times could be here for a while, so I do understand why they're potentially taking on more risk. And keep in mind as well, even with that net credit loss growth, they're still at the bottom of the net credit loss ranges they've said they're comfortable with. So, if you trust management and you think that they are running the bank well, then you probably feel OK about that. One other thing I'll highlight: they're still winding down their legacy assets, mortgages in particular, which will keep impacting top and bottom line results for a while going forward. But overall, I thought things looked pretty good at Citigroup.

Frankel: They did. One thing I would like to point out about banks like Citigroup that have big credit card businesses -- a lot of Citigroup's loans come from credit cards. I have a Citigroup credit card in my pocket as I'm talking. Credit card purchase volumes have shot up over the past few years. It's a sign of growing consumer confidence and a general healthy economy. But at some point, you have to keep an eye out for the credit card losses to start creeping up, which, it looks like that might be happening now. As you said, Citi's net credit losses went up 7% year-over-year. A few of the banks are starting to see a small uptick in credit card -- I know, one company I follow closely is Synchrony, which we talked about in another podcast, just because they're credit card specific, it's really good insight on the industry, and theirs have really started to creep up over the past few quarters. So, for any bank, I would say, that's heavily into credit cards -- Citi, Bank of America, JPMorgan Chase, Wells Fargo is definitely big into credit cards -- any of those, keep an eye on the default rates over the next few quarters. This can give you clues that the economy might be getting a little ahead of itself.

Douglass: Yes. That's good. Frankly, Matt and I love financials, and a big part of that is thinking about conservatism in who you loan out to. We tend to, I think both, get a little bit uncomfortable as folks start lending more and more and more, and therefore increasing their risk profiles. 

With that in mind, Bank of America, really good results on the consumer banking side. Deposits are up 8-9%, loans up about the same amount. Given that's where they're getting their best return on average allocated capital, which is 24%, it makes sense to focus their efforts there where possible. Brokerage assets, of which my accounts are a part, are up a stunning 22%, which reflects some really impressive inflows in addition to, of course, good market returns. Frankly, they're filing on most cylinders. You look, they've reduced branch count by 41 just this last quarter. Mobile banking active users are up 12% year over year last quarter. Across the board, it looks pretty good at Bank of America to me.

Frankel: Citigroup has done well. Bank of America is hands-down the biggest transformation since the financial crisis.

Douglass: Absolutely. 

Frankel: Like you said, in mobile, about a quarter of Bank of America's deposits now come from their mobile app. A quarter of the entire bank's deposits. This is a big boost in efficiency for them. They're firing on all cylinders. Their brokerage assets are up because the narrow-edged platform is excellent. It was a very smart move, being able to integrate that into Bank of America's accounts. It gives them a big leg up over a, say, a TD Ameritrade or an E*Trade, just in terms of being able to cross-sell a great product to their customers, and reducing branch counts, being more tech efficient, it's been a recipe for success for them so far. Bank of America is the new Wells Fargo, as I said in one of my recent articles.

Douglass: I think that's probably fair. There's good reason to see it as a darling. And JPMorgan, let's be clear and give them due credit as well, they've had a pretty good quarter as well. A wee bit weaker on the trading side, of course. But frankly, wealth management, revenue of $3.4 billion, it's up 9% year-over-year. Net income is up 12% in that division. Consumer and business banking up 16%, card up 11% year-over-year. 20% growth in revenue, 39% gross in net income for commercial banking. For me, it's hard to overstate how well JPM is doing ex-trading, and how good it looked coming out of this quarter's earnings. I'll also particularly call out the credit card again. Given how much they've spent and how much they've done to make things like Chase Sapphire really work with consumers, it's great to see all of those initiatives panning out so well for them.

Frankel: If trading revenue turns around, JPMorgan could be a force to be reckoned with.

Douglass: Right.

Frankel: This was their best quarter in a long time. We were actually, before the podcast, chatting about how JPMorgan has had a few questionable quarters. But this was a good one.

Douglass: Yeah. Let's head over to the investment banks. Much, much more mixed picture coming out of them. These are, again, Morgan Stanley and Goldman Sachs. For me, one of the big things that I came out with is, Morgan Stanley said, advisory revenues declined, and I'm quoting here, "on lower levels of completed M&A activity." Goldman Sachs, of course, saw an increase in M&A transactions and maintained its first-place spot. So, when you are struggling to get M&A deals and your competitor is getting them, that's a pretty bad sign.

Frankel: Yeah. And to be fair, Morgan Stanley had a very good fourth quarter last year, so the fact that it dropped isn't necessarily all that it appears to be. But, you're right, that sounds kind of like a sneaky way of saying they lost a little bit of market share. But, Goldman's M&A business was firing on all cylinders. 2017 in general was a great year for M&A activity. As generally happens a few years into a bull market, companies can get more from and acquire, companies have more to spend, it's just a great environment. So, that's definitely a big point of concern.

Douglass: Of course, flip side, Goldman Sachs had its own points of concerns. Their wealth management had negative outflows for the quarter.

Frankel: Yeah. It was only about $1 billion, but this is the first time in a while I noticed Goldman Sachs had money flowing out of their asset management business. Their assets under management are definitely up for the year, just because the markets have been doing so well. But, this means people withdrew $1 billion more from Goldman Sachs' brokerage accounts than they put in. Morgan Stanley, on the other hand, saw about $20 billion of inflows, meaning that people are pumping money into those accounts. So, that's, on the other hand, an area of concern for Goldman that's not so much of an area of concern for Morgan Stanley.

Douglass: Yeah, it's funny, these two banks each did better in one area than the other and flubbed it a little bit on the other. So, that's certainly something for us to dig more into. I'll certainly be interested to see how that works next quarter. Let's turn to the commercial banks -- USB and Wells. Want to talk USB first?

Frankel: Yeah. USB is one of the most boring banks to talk about because they always do well.

Douglass: [laughs] Darn, so hard!

Frankel: I mean, return on equity of 13.4%, return on assets of 1.33%. That's the best you're going to see out of the big banks every quarter. One thing I will say about USB, and Wells Fargo, for that matter, these banks actually got a tax benefit. They were carrying deferred tax liabilities on their balance sheets. USB actually got a $910 million benefit, Wells got a little over a $3 billion benefit from tax liabilities that they would have had to pay at that 35% rate but are now being valued at a 21% rate. So, they actually got a nice benefit from that. And the ROE and ROA numbers I just read for USB are after that benefit. So, including that benefit, they're even better. Their interest margin rose by 10 basis points. Net interest income up by over 6%. They had a really predictably good year.

Douglass: Yes. That's the thing with USB. It's always -- well, at least for a while, it's been predictable and good. Let's talk about Wells a little bit. Obviously, there was the big legal charge, $3.25 billion. That's not exactly great headline news.

Frankel: No. That was actually just offset by the tax benefit they got. They actually came out a little bit ahead on that. But, we talked about this in a recent episode, this was not a good year for Wells Fargo. And you can tell that by the atmosphere on the earnings call, reading the comments in the earnings release -- management wants to talk about what happens next, in 2018 and 2019. In 2017, Wells Fargo was the only big bank I've seen whose loan portfolio shrunk by a little over 1%. And when everyone else's loan portfolio was getting 6-7% bigger, that's a big deal. For the full year, return on equity and return on assets looked good. But Wells Fargo is more of a question of, can they get past the public perception affecting them right now? If you think they can, then it looks like a good buy right now. They're doing a great job of cost-cutting, I will say. They say they remain on track to cut $2 billion worth of ongoing costs by the end of 2018 and want to do another $2 billion in 2019. So, they're trying to make their operation a little more efficient, it's just whether their revenue growth, loan growth, deposit growth will be in line with the rest of the industry, is the question.

Douglass: Yeah. That makes a lot of sense. Stepping back now and thinking big picture about each of these specific banks, which bank most changed your viewpoints with this quarterly release?

Frankel: I'd say Goldman. Not that I'm opposed to Goldman right now, I still think it's a great long-term investment, it just kind of made me a little more cautious. Goldman rarely gives you things that make you jump back and say, "Woah, that shouldn't be." The downflows that we talked about, and the massive drop in trading revenue that was the worst in the industry was another one. So, there were a few things that made me take a step back and say, "Eh, maybe I'll hold off for a little bit."

Douglass: Yeah. And I'll say, I have historically not been a huge JPM fan. Not that I've disliked it, to be clear, I've just not been its hugest fan. But I have to say, again, ex-trading, it looked pretty darn good. Again, to see 9% growth in their wealth management, 20% growth in commercial banking revenue and 39% net income, across-the-board, I thought things looked really good at JPM, and that's great news for shareholders of that business. So, I'm a lot more bullish on JPM than I have been historically.

Definitely a lot of interesting stuff for us to come away with. If you have any thoughts on any of the big banks or want to hear our thoughts on any part of it, shoot us an email, [email protected]. Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at [email protected]. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!