What happened

The stock market isn't having an excellent day on Wednesday. As of 11 a.m. EDT today, the Dow Jones Industrial Average and the S&P 500 index were both down by about 2.7%.

Among the worst-performing parts of the market was the financial sector, and the big banks are getting hit especially hard after reporting their first-quarter earnings. JPMorgan Chase (JPM -1.19%) and Wells Fargo (WFC -1.46%) are down by 5% and 6%, respectively, adding to their post-earnings losses, and Citigroup (C -1.04%) is down by 3.5% after reporting its earnings earlier today.

Young woman with shocked expression.

Banks are setting aside shocking amounts of money to cover expected defaults. Image source: Getty Images.

So what

To be clear, bank stock earnings weren't terrible. But then again, the U.S. economy was pretty normal for about two-thirds of the first quarter. JPMorgan's revenue dropped by just 3% year over year, while Citigroup's actually grew. And all three of these banks grew their loan and deposit portfolios when compared with the first quarter of 2019.

The thing that seems to be scaring investors more than anything is the massive reserve builds by these banks. In simple terms, banks always set money aside to cover expected loan defaults, but in good times, default rates are rather low. Some of the reserve numbers we're seeing, however, show that the banks are bracing for a massive wave of defaults:

  • JPMorgan Chase added $8.3 billion to its loan loss reserves. For context, this is $6.8 billion more than it set aside during the first quarter of 2019.
  • Wells Fargo set aside $4 billion to cover losses, $3.1 billion more than a year ago.
  • Citigroup added $4.9 billion to its reserves in the first quarter. It added just $20 million in the first quarter of last year.

Another point worth noting is that while most areas of consumer banking are likely to do poorly during the coronavirus pandemic, the same can't be said for some aspects of investment banking. Specifically, when markets get volatile, trading activity in both fixed income and equities tends to accelerate. In fact, JPMorgan Chase reported record trading revenue during the first quarter, and keep in mind that the market was relatively stable until March. And the fact that many companies need to raise capital can be a positive catalyst for equity and debt underwriting as well.

This could explain why Wells Fargo is getting hit worse than the other two, since it is the only one of the three that doesn't have a significant investment-banking operation. In other words, it is dealing with the potential downsides of the crisis (higher loan losses, reduced demand, lower interest margins), without the silver lining of a boost to trading revenue.

Now what

The key takeaway from a bank investor's perspective is that nobody knows how this recession is going affect consumers' ability to pay their bills. And some of these reserve builds are more than investors had expected to see. Whether the actual losses experienced by these banks are more or less than the reserve amounts remains to be seen, but for now, investors seem to be taking a cautious approach.