For the first time in 18 quarters, Wells Fargo (NYSE:WFC) failed to report an increase in quarterly net income. Senior banking specialist John Maxwell explains why shareholders shouldn't see this as a sign of trouble, and outlines what to expect from Wells Fargo when interest rates inevitably rise.

Meanwhile a difficult fourth quarter last year led some shareholders to call on JPMorgan (NYSE:JPM) to split up into its component parts. Was that good advice at the time? Is it now? Maxfield discusses the implications of such a split, both for JPMorgan itself and in the greater global context.

A full transcript follows the video.

Kristine Harjes: Checking the pulse on big banks; this is Industry Focus.


Welcome to Industry Focus financials. For The Motley Fool this is Kristine Harjes, and I'm joined by senior banking specialist John Maxfield on the line.

John, it's great to have you. Hello!

John Maxfield: Hello! It's always great to be with you, Kristine.

Harjes: As we alluded to on last Monday's episode, this week kicked off earnings season with bank earnings front and center of our attention. Overall it wasn't really a terribly exciting quarter for banks.

Maxfield: But that's not necessarily a bad thing of course, Kristine. If you think about any industry where you want "boring," banking is definitely the industry you want to see that in.

Harjes: I agree wholeheartedly.

Some common threads that we saw included fairly successful cost-cutting measures across the board, which along with some reduced legal expenses boosted profitability for a number of the major U.S. banks.

On the other hand, though, we saw some extremely low interest rate environment effects that have been make it really hard for these banks to expand their profitability and their net interest margins.

On that note, I think Wells Fargo would be a really good bank for us to dig into, to see an example of this effect and what it's having on traditional banks. It was the first time that quarterly income didn't increase for Wells Fargo, after an 18-quarter streak.

John, can you shed some light? Should investors in Wells Fargo be concerned?

Maxfield: First, let me just answer that really straightforwardly: No, investors in Wells Fargo should absolutely not be concerned, and here's why.

When you look at Wells Fargo, to your point, they've grown their quarterly net income on a year over year basis for 18 consecutive quarters before this most recent one. The question is, what happened in this most recent quarter that caused this trend to come to an end?

There are really two things that contributed to that. The biggest one, and this is something you already mentioned, was the continued low interest rates.

A bank like Wells Fargo, which is a traditional bank -- it takes deposits and then it makes loans -- they make money by arbitraging interest rates. You put money in a checking account, you get 0% interest rate on that, or maybe 10 basis points on it or something like that.

Then they loan that same exact money out, at say 3.5% or 4%. Any time interest rates are really low, those loans are indexed typically, to interest rates, so the money they're going to take in from that is going to be much, much lower.

Now, if short-term interest rates go up then they'll obviously take more money in, in revenue from those loans. But they won't pay as much out.

If you normalize for the increase in the cost relative to the increase in the earnings they'll take from their asset portfolio, their cost won't increase as much because a lot of those deposits and a lot of a bank's liabilities are non-interest bearing. They're non-interest bearing whether interest rates are high or whether they're low.

On a year over year basis, if you just normalize for interest rates, Wells Fargo would have earned something like $1 billion more in revenue, and therefore net income, if interest rates didn't continue to go down.

What that says to me is that once interest rates do start going up, there's a lot of captive net income and captive revenue in Wells Fargo that will come out once that finally happens.

Harjes: A billion dollars. That's a big figure right there. How do you arrive at that number?

Maxfield: The way that banks articulate how much money they're earning from their asset portfolio, which holds loans and securities, is through the net interest margin. The net interest margin is basically a formula that tells you how much income a bank is earning off its earning asset portfolio.

Let's say that a bank has a portfolio of $100 million and it earns, say $3 million in interest income from that. Its net interest margin would be 3%. Wells Fargo's fell from 3.2% last year to below 3% this year. It's that difference between last year's net interest margin and this year's net interest margin that accounts for that $1 billion of captive income.

Harjes: Just that little bit, that 0.2%, apparently could make a huge difference.

Maxfield: That's exactly right. Think about it; I don't have the number off the top of my head, but they have something like $1.7 trillion in assets, and I think something like 85% of those are earning assets.

You're talking about the difference between 3.20% on $1.5 trillion in assets, and 2.95% on $1.5 trillion in assets. So, while the percentage may seem really small, because the assets are so enormous it equates to a relatively large number.

Harjes: How are those assets trending? Is Wells Fargo doing anything to anticipate a potential increase in interest rates?

Maxfield: That's a great question, because Wells Fargo actually is purposely setting up its asset portfolio so when interest rates do rise, it will be able to take advantage of that. To look at it another way, they won't be hurt as much by that immediate increase in interest rates as other banks will be.

When you're dealing with banks and you're talking interest rates, you have to keep two things in mind. First, when interest rates go up, banks will make more income.

However, the securities in their securities portfolio will have to be written down in value when interest rates rise because a security's value is inversely related to interest rates; interest rates go up, security values go down.

What you want to do as a bank is, if you anticipate interest rates are going up, you want to keep your portfolio really, really liquid. You don't want to have a lot of long-term securities. You want short-term securities that aren't affected in their value as much in that original uptick, and that is what Wells Fargo has done.

But by increasing the liquidity on its balance sheet, it's decreased its net income that it's earning from that. But again, this is just a temporary thing that will pay off in spades once interest rates do in fact increase, whenever that comes to fruition.

Harjes: Interesting. It seems like, on the whole, Wells Fargo investors actually have a lot to feel really optimistic about.

Maxfield: I would say that. I mean, its shares aren't cheap. Wells Fargo's shares typically, over the years, have traded for 2 times book value, or a little bit less than 2 times book value.

But because it keeps its expenses so low, and because it's so well run and manages its credit risk so well, it can return 14-15% on its equity so you could still make a ton of money by investing in Wells Fargo, even at an expensive price, so long as you're willing to hold their shares for a very long time.

Harjes: There you go. That's one promising story to keep an eye on. Let's shift our attention over to the company that was at the forefront of last week's conversation, JPMorgan. Is there a story that stands out to you from their quarterly report?

Maxfield: The big story with JPMorgan is that in the fourth quarter of 2014 a lot of people came to JPMorgan saying -- and this is on JPMorgan's conference call -- "Look, you guys would be more profitable if you were to break up JPMorgan into its component pieces."

Specifically, when you talk about breaking a bank like JPMorgan up into its component pieces, you talk about an investment banking side and your traditional banking side.

Investment banking, that's your traditional Wall Street operations; your trading, your merger & acquisition advisory business, your equity underwriting, your debt underwriting, all those types of things.

The fourth quarter of last year was a really tough quarter for Wall Street operations because there was a ton of volatility in the fixed income markets, thanks to what was going on in the oil market -- the decline in oil prices -- and also because of the Swiss National Bank's decision to unpeg its currency from the euro.

You had all these things go on that hit the trading operations on Wall Street banks. That dropped their revenue way, way down from that side of the operation, and caused people to wonder whether or not JPMorgan should be broken up.

But then this quarter it was the exact opposite. Volatility was way down in fixed income markets, there's a lot of activity going on in terms of mergers and acquisitions and other types of advisory work, so JPMorgan saw a huge boost in its investment banking operations.

In fact, its advisory operations from saw their net revenue increase by 26% on a year over year basis, which is a huge amount. That kind of muffled any calls for JPMorgan to break up, so it was really a vindication, if you will, for CEO Jamie Dimon.

Harjes: Interesting. What do you think? Is that rightly so, or do you think maybe they should still consider breaking up?

Maxfield: You can look at banks like JPMorgan through a number of different contexts, but one of them is that a bank like JPMorgan is absolutely critical for the United States to continue to hold its economic position in the world, particularly vis-à-vis China because China has very large banks that are starting to go out and do multinational work, do work for other clients, etc.

These are becoming huge banks that are able to do a variety of different things. If we want U.S. banks to be able to compete in the future against banks like that, they've got to be able to not only have the size that is necessary to serve large multinational clients, but they also have to have the diversity of products.

What I mean by that is that a bank has got to be able to both do investment banking stuff, and your traditional deposit taking and loan making and setting up syndicates for loans, in order to be a one-stop shop for these multinational companies.

That is a really important thing for the United States, so for that reason I personally think that we would want JPMorgan to stay together.

On top of that, JPMorgan is run by, if not the best banker in the country, certainly one of a small handful of the top bankers in the United States right now. If Jamie Dimon makes the decision, "I think that we're a better bank, taken together," I think that his history gives him credibility in that determination better than, say someone like me or any other random bank analyst.

Harjes: Good stuff! John, on a different note, the Boston Marathon was this morning. It started with the first heat at I think 8:50 in the morning. Obviously, this is the very historical 26.2-mile race.

In the spirit of incredible performance by the 30,000 participants, my final question of the day for you is: Is there a bank that you would be comfortable buying and holding for 26.2 years?

Maxfield: I love that! That is a great question. Yes, absolutely. There are, let me think ... two banks in particular that I would feel as comfortable as you can feel about owning a bank for a long time.

I would feel comfortable owning Wells Fargo for many decades, and I would feel comfortable owning US Bancorp (NYSE:USB) for many decades.

I live in Portland, Oregon and U.S. Bank, even though it's based in Minneapolis, the U.S. Bank it gets its name from was actually based on Portland, Oregon, so there are a lot of old-time U.S. Bank shareholders in Portland, many of whom are extremely wealthy, just because of their US Bancorp stocks that they've held for many decades.

Harjes: You're saying you're biased!

Maxfield: I think that US Bancorp's future, as best we can guess, probably will look somewhat similar to its past in that regard.

Harjes: Great! Well, there you have it folks, your Foolish reminder that the most successful investing is a marathon and not a sprint.

As usual, if you've got any questions for myself or John, please send them our way. Our email address is We'll look forward to hearing from you! I hope everyone has an awesome week. Until next time!

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.

John Maxfield has no position in any stocks mentioned. Kristine Harjes has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of JPMorgan Chase and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.