A Big Quarter for Bank Stocks: Here's What to Expect

All of the big banks announce earnings over the next week, with JPMorgan Chase (NYSE: JPM) kicking things off tomorrow.

What should you expect?                                                                        

Here are three areas I'd pay special attention to.

1. Fixed-income trading
Fixed-income trading has singlehandedly kept banks' bottom lines intact for the past 15 months. Chalk this up to an exceptionally fat yield curve, a government that can't sell enough Treasuries, and consumers plowing headlong into the anticipated safety of bonds.

That this gravy train will end is guaranteed; when is the question. Although no one knows, there's one reason to think this quarter's fixed-income profits will keep up with the previous trend: Jefferies.

Jefferies is a small New York bank that gets zero attention, yet operationally it looks a lot like Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS). It reported second-quarter earnings three weeks ago, providing a sneak preview into the industry.

Jefferies increased fixed-income trading revenues by 8.2% sequentially. This doesn't guarantee anything for other banks, but it suggests that industrywide fixed-income profits won't stray far from their recent averages. Fixed-income profits are primarily driven by macro factors, not the talent of individual banks, so it's fair to extrapolate one bank's results to the rest of the industry.

Here's how fixed-income trading contributed to the big picture during the first quarter:

Source: Company filings, author's calculations.

2. Blown-out debt spreads
When banks look like they're in trouble, the value of their debt falls. Under one of the nuttiest accounting rules known to man, they're then allowed to count this event as net income. The idea is that a bank could theoretically buy back its own debt at a discount, hence creating value for its shareholders. (I don't get it either.)

Banks were stung by several setbacks in the second quarter, including Greek mayhem, a dawdling recovery, and uncertainty over financial reform. That sent their credit default swaps soaring, which implies lower bond prices, which counts as net income. Put simply, the more investors worry about banks, the more profitable those banks become. As Charlie Munger once put it, "Anyone with an engineering frame of mind will look at accounting standards and want to throw up in the aisle."

Bloomberg reports Bank of America could log as much as $1 billion profit this quarter thanks to the deterioration of its own bonds. Citigroup and Morgan Stanley are also customary beneficiaries of this rule.

When accountants play this game, it's tremendously important not to take the headline earnings number seriously. You have to back out whatever gain comes from blown-out debt spreads in order to get a clear view of reality.

Unless the bank actually repurchases its own debt, there's no possible outcome where the recorded gains become permanent net income. Either the market is right and the bank is headed toward bankruptcy (unlikely), or the debt prices will recover (more likely), in which case the bank will have to reverse the gains into future losses. In either case, it's a senseless rule that harms anyone who takes it seriously.

3. Dividends
Between raising enormous amounts of capital and hoarding cash to boost liquidity, banks' balance sheets appear plenty strong today (although those are famous last words). That raises the question of when they'll resume paying regular dividends.

They may fairly soon. In this year's letter to shareholders, JPMorgan Chase CEO Jamie Dimon wrote that in order to reinstate the company's dividend back to normal levels "we would like to see three specific things happen: several months of actual improvement in U.S. employment; a significant reduction in consumer charge-offs (which improves earnings and diminishes the need for additional loan loss reserves); and more certainty around the regulatory requirements for bank capital levels."

While gains have been frail, the private sector has added jobs for five consecutive months. Check. Credit card delinquencies have been falling for six consecutive months. Check. And Congress looks like it's wrapped up negotiating details of the financial regulatory bill. Check.

Three banks I'd watch for dividend announcements are JPMorgan, Bank of America, and Wells Fargo (NYSE: WFC). The other big semicommercial bank, Citigroup, can't pay any significant dividends as long as the U.S. Treasury remains a common shareholder, which, truth be told, might not be for much longer.

Your thoughts, please?
What do you think about the banking sector this quarter? Fire your views off in the comments section below.