Bank Earnings: 3 Things Investors Need to Look For

This is a big week for the banking sector, with the top five U.S. banks reporting fourth-quarter results, starting with JPMorgan Chase (JPM 0.65%) and Wells Fargo (which have already reported), then Bank of America (BAC 1.53%) and Citigroup (C 0.26%) on Thursday, and, finally, Goldman Sachs on Friday. Here are three areas that business-oriented, long-term investors will want to pay attention to as they review the earnings reports -- and the stocks.

Watch your capital return
Last month, the Federal Reserve announced that eight banks -- the five listed above, along with Morgan Stanley, Bank of New York Mellon, and State Street -- had an aggregate capital shortfall of $21 billion under new capital requirements that will exceed those mandated under post-crisis international norms (the Fed has already approved the capital surcharges, which must undergo a public consultation). However, it then emerged that JPMorgan Chase accounted for the entire deficit on its own! In fact, the Fed estimated JPMorgan's capital shortfall at a whopping $22 billion, with the other seven banks already meeting the central bank's standards. For reference, JPMorgan earned $22.1 billion in net income during the trailing 12 months.

That observed shortfall could well impact JPMorgan's 2015 dividend and stock buyback program, which must be approved by the Federal Reserve. In order to fill the "hole," the Fed could effectively order the bank to reduce its dividends and/or share repurchases. The assessment will be made as part of the central bank's annual Comprehensive Capital Analysis and Review (better known as the "stress tests"); banks submitted their capital plans by Jan. 5.

This topic will also be a source of major interest at Citigroup, after the Fed rejected its capital return program last year in an embarrassing setback for the bank -- at present, Citi remains the only top bank that continues to a pay a nominal dividend of $0.01 per quarter.

Legal expenses: The end is (nearly) in sight
Citigroup's woes appear almost never-ending (which, incidentally, has masked the tremendous progress it has made since the depths of the credit crisis). A month ago, CEO Michael Corbat surprised investors by announcing the bank would book a $2.7 billion litigation charge for the fourth quarter, which, when added to $800 million in "repositioning" charges, would take the bank from an expected $3.4 billion quarterly profit to being "marginally profitable."

The litigation charge was linked to government investigations into the alleged manipulation of foreign exchange markets and interest rates, along with poor compliance with money-laundering rules. In November, Citi and JPMorgan Chase were the hardest-hit banks in the first round of settlements resulting from the probe by multiple national regulators into the manipulation of foreign exchange benchmark rates, each paying roughly $1 billion. Incredibly, additional (multi)billion-dollar fines and/or settlements could still be in the pipeline, as the U.S. Department of Justice continues its investigation.

The far-reaching foreign exchange probe was also behind Bank of America's surprise restatement of its third-quarter results last year, from a small profit to a loss. Although the end of the tunnel of massive legal expenses due to banks' boom-era misbehavior appears finally to be in sight, investors will want to know where JPMorgan, Citi, and BofA stand with regard to the Justice Department's investigation.

Source: YCharts.

Less profitable, yes, but much cheaper, too
The points I highlighted above might seem negative, but institutional investors are apparently undeterred: According to a Morgan Stanley survey of its buy-side clients, 81% of those investors are either equal weight or overweight financials in their portfolios. Putting that figure in context, the broker noted it is "in line with the bullishness for 2014 (84%) and among the highest since we began the survey five years ago."

Normally, that degree of consensus would give a contrarian like me pause. In this case, however, it doesn't disturb me. The top five banks are safer now than they have been in over a decade. Yes, operating profitability is lower as a direct result of regulators' actions, but the banks remain nicely profitable and, crucially, the shares are reasonably priced on an absolute basis, certainly relative to the market (see table above). I don't expect eye-popping returns from this group over the next three to five years, but I think their performance ought to be more than adequate.