This Indicator Shows Trouble for Big Banks

 | May 22, 2013 | 5:00 PM EDT  | Comments
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Stock quotes in this article:

jpm

,

c

,

wfc

,

bac

In recent columns, I have referenced different aspects of the financial and business situation that the money centers (JPMorgan (JPM), Citigroup (C), Wells Fargo (WFC) and Bank of America (BAC)) are in and the implied trajectory for each, as indicated by the performance of the past few years.

The three fundamental financial issues to be tracked and then related to each other are revenue, earnings and legacy issues. These issues need to be viewed with an understanding of each company's business strategy and focus.

I discussed the distinct business strategies of the money centers in the column "Big Four Money Centers Have Different Strategies," but I will address them briefly here again. The basic breakdown is that JPMorgan and Citigroup are focused internationally, while Wells Fargo and Bank of America are focused domestically.

JPMorgan has decided to postpone dealing with its legacy issues from the financial crisis and to instead focus on expanding its international business, with a goal of displacing Citigroup as the dominant U.S.-based financial institution.

This opening for JPMorgan appeared because, since the crisis of 2008, Citigroup has been primarily focused on cleaning up its balance sheet and legacy issues, and it has made growing new business a secondary concern.

And Citigroup has been successful for the most part. It is much further along than the other money centers in resolving its legacy issues, and it should be refocusing on growing the business again imminently. 

While JPMorgan and Citigroup compete internationally, the domestic-based banking business is left to Wells and Bank of America. The domestic market is dominated by the residential mortgage industry. As it stands now, Wells Fargo essentially is the U.S. mortgage market, having now, in many respects, replaced the roles that used to be served by Lehman Brothers, Bear Stearns, Fannie Mae and Freddie Mac.

Bank of America's almost sole focus on resolving legacy issues and its inability to do so has left Wells Fargo as the dominant U.S. mortgage lender by default.

All four money centers, though, still have legacy issues that are severe and should be highlighted. Most investors' concerns about these issues dissipated after only Citigroup failed the stress tests that the Federal Reserve conducted last year.   

One of the best ways of understanding the relationship between revenue and earnings on one side and asset problems on the other is to use what is known as the Texas Ratio.

The Texas Ratio is the value of nonperforming assets divided by tangible equity and loan-loss reserves. To get a more accurate representation of the riskiness of the financial situation a bank is in, use a modified Texas Ratio, in which the value of the federal government's guaranteed support is subtracted from the value of the nonperforming assets. Nonperforming assets are mostly loans that are in default and real estate that has been acquired through foreclosure.

There are other ways to refine the issues, such as removing restructured loans from consideration as nonperforming. In another column I'll write about what we can learn from these various ways of measuring the Texas Ratio. The numbers in this column are calculated using all nonperforming loans minus government guarantees.

Before the financial crisis of 2008, the long-run banking industry average since the savings-and-loan crisis was resolved had been about 5%. That is, the value of nonperforming assets as a percentage of equity and loss reserves was about 5%. That number hit an industry aggregate average high of 33% in the first quarter of 2010, and it has declined to only about 20%.

JPMorgan hit a Texas Ratio high of 45% in the first quarter of 2011 and is now about 25%. Wells Fargo hit a high of about 45% in the second quarter of 2010 and is now about 30%. Bank of America hit a high of about 35% the first quarter of 2011 and is now about 30%. Citigroup hit its high back in the fourth quarter of 2008 of about 30%, and it is now down to about 18%.

All four are still very high, indicating legacy issues of nonperforming loans and foreclosed real estate being carried that will take many more years to resolve and bring the ratio back to long-term trends.  

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