Early Takeaways on Banks' Earnings

 | Jul 19, 2013 | 9:00 AM EDT
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Now that the second-quarter earnings reports have begun for the banks, investors can start to form a picture of the recent performance and outlook for financial stocks. Let's review what a number of the largest companies in the group have said about their businesses, the business and regulatory environments, and their prospects, all to the goal of reaching some working conclusions.

JPMorgan Chase (JPM) led the parade with another in its long line of consensus-beating performances, reporting a normalized EPS beat of a few pennies and strength across a broad array of its businesses. Fee revenues at the investment bank and in asset management were strong, but net interest margin shrank again.

Credit quality throughout the bank continued to improve, prompting more reserve releases. The recent backup in interest rates has begun to impinge on its mortgage business, but higher interest rates resulting from an economic improvement will benefit JPMorgan overall. Management was adamant that the bank will easily manage through the tighter capital requirements that will be coming over the next few years.

Later that day, Wells Fargo (WFC) also reported better-than-expected earnings. Even though Wells Fargo is very large in terms of assets, its business mix is much more straightforward than JPMorgan's, taking deposits and making loans (mainly mortgages). Again, fee income was the standout, while its credit losses were lower than forecast. Expenses were well controlled, and that played a part in its high returns on equity and assets. Importantly, Wells' capital ratios are best in class, and that will allow the company to continue to reward shareholders with dividend increases and share repurchases.

Earlier this week, we heard from Citigroup (C), a more complex bank like JPMorgan, which has the added complication of a large run-off business. Again, Citigroup reported beats on both the top and bottom lines, mainly driven by fee income. Its comments about the future contained some caution about continued spread compression and pressure on mortgage originations from higher interest rates. Citigroup also reported some incremental progress in resolving its legacy assets and reducing the related costs.

Finally, Goldman Sachs (GS) produced the best results of the group, far surpassing estimates for both revenue and earnings, though some of the gains resulted from a temporarily lower tax rate. Much of Goldman's beat came from excellent trading performance, especially on debt instruments. Expenses were in line with expectations. The company's mediocre return on equity was probably the one blemish on an otherwise good report. Its capital is strong when measured under the Basel III standards, but management was vague about its current standing compared with the recently promulgated leverage ratio.

A few general lessons can be extrapolated from these four specific earnings reports. Taken together, these four major banks reported solid to strong results for the second quarter, generally benefiting from good trading results, reasonable expense controls and outstanding credit performance.

Nevertheless, two major issues are on the horizon. First, as interest rates increase, the volume of mortgage originations will suffer, especially for refinances. For most companies in the financial sector, we believe this will be more than offset by a more normal yield curve and an improving net interest margin. Also, if higher rates are reflective of an improving economy, loan volumes will grow as well. Second, increasing regulatory requirements will limit the flexibility of the banks, by forcing them to reduce exposure to risky but profitable businesses, and by retaining more capital that might otherwise be used to invest or to reward shareholders.

We believe the superior management teams at each of these companies can successfully navigate both of these issues in good form. Valuations for this group have recovered from the lows reached during the hysteria of the financial crisis of 2008-9, but not fully, and only because the disaster scenario is off the table.

As the economy continues to normalize, and with it the interest rate environment, earnings will continue to grow, and bank valuations can still expand. We believe that financials will still be leaders and will outperform the market during the remainder of the year.

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