Bank Earnings Taxed by QE2, Massive Regulation
Forget about Cyprus, a land of stifling heat and Russian hostess bars. It’s time once again for bank earnings. In Q1 2013, the themes are peaking mortgage banking revenues and almost no reserve releases to pad results. Even as some of the biggest banks are (supposedly) reporting record mortgage banking revenues coming off of the refinance boom of 2012, these same institutions are laying off thousands of front office personnel from, you guessed it, the mortgage department.
As I noted in a presentation to American Enterprise Institute this week, the combination of Basel III, Dodd-Frank and the ongoing inquisition over foreclosure abuse will force the commercial banks out of the mortgage business over the next several years. The TBTF banks may be, well, big and dumb, but they are not going to continue producing mortgage loans if their cost to process these assets is 2x their profit – even including the gain on sale. Nobody in Washington understands what the combination of regulations and court decisions is doing to the world of mortgage finance.
Jay Brinkman, chief economist of the Mortgage Bankers Association, noted in a presentation to the same American Enterprise Institute audience that the cost to a bank to originate a new mortgage loan is over $5,000 today, a significant data point since that amount is 2x the average income to the bank from the same loan and several times the pre-crisis cost. Just imagine how financial markets will react when Wells Fargo, the largest US mortgage lender, announces its withdrawal from much of the mortgage business. My friend Mark Fogarty, veteran mortgage market watcher at Source Media, reminds us that Wells actually did drop out of the mortgage business in 1990 after the S&L crisis. (This graph is from a longer article on the mortgage market to be published in http://nationalinterest.org/ next week.)
With Dick Bove predicting record bank earnings in Q1, it is useful to recall that all US banks made $33 billion in operating income last quarter. The record quarter for the industry was $37.5 billion in Q2 2006, so what Dick is basically saying is that the industry could meet or beat $40 billion in net income. Even with the decline of reserve releases relative to the last several years, mortgage revenue could account for a large chunk of earnings. The industry sold $641 billion worth of loans into securitizations in Q4 2012, down 12% YOY, but servicing revenue nearly doubled to almost $5 billion. The drop in loan volumes is why the POTUS invited the banksters to the White House two weeks hence to talk about “opening the spigot” for mortgage finance.
As the chart above shows, bank dividends have just about caught up with net income, meaning that the banks are giving roughly amounts equal to operating income to shareholders. The Fed blesses this transfer even though most of the large banks are still woefully undercapitalized vs. their true risks. If you understand the difference between nominal and risk weighted assets, no more need be said. If not, read FDIC Vice Chairman Tom Hoenig in a speech last week that despite the higher capital standards implied by Basel III, the effect is largely an illusion in terms of reducing the riskiness of large banks.
Notice in the chart how much larger was the destruction of value by the banking industry during the subprime crisis vs. the S&L bust in nominals terms, when losses reached almost -$40 billion and dividends just about disappeared. In real terms, the numbers are pretty close. If systemic risk were taxed as some influential members of Congress are considering, what would the dividend flow of US banks look like?
So let’s wander through the banks reporting today and see what to expect. First is JPMorganChase, which is currently rated “A” by Institutional Risk Analytics. The bank’s tier one leverage ratio is just 6%, but its ratio of tier one capital to risk weighted assets is 14%. You get the joke now? The leverage ratio is the measure that matters. The bank also had a slightly negative RAROC as of 12/31/12, meaning that the bank’s income is not actually positive vs. risk taken.
With a price to book of just under 1, JPM is actually considered cheap by many analysts. The market value of equity is up about as much as home prices YOY, some 9% for those of you who get out less than most, and the 1.6 beta is about right for a large money center bank. The Street has JPM down revenue 5.4% in Q1, but up double digits in Q2 2013 and finishing the year up less than one percent. The fact that the bank is laying off people in the mortgage unit, sad to say, tells the story on future volumes, but earnings are supposed to be up 5% for 2013 and 7.4% next year.
Wells Fargo was also rated “A” by Institutional Risk Analytics at the end of 2012. Of note, WFC’s tier one leverage ratio is two points better than JPM, but its ratio of tier one capital to risk weighted assets is just 12%, reflecting the different business mix of the nation’s largest mortgage originator. WFC had a positive RAROC of 3.4% as of 12/31/13. The market value of equity is up 10% YOY.
Net servicing fees were down almost $2 billion in Q4 to $1.4 billion and net securitization income was just $150 million, but net income was almost $19 billion in Q4 2012 up 19% YOY. This was more than half of the total industry income in the quarter, but only a quarter of the subsidy the Fed is giving the banks because of QE2. As I noted in the AEI deck, the cost of the funds for the entire US banking sector was just $15 billion at the end of Q4 2012 – a direct tax upon individual and corporate savers c/o Ben Bernanke and the FOMC. But banks are savers too.
WFC trades on a 1.2 beta, a good bit less volatile than JPM or Citigroup at 1.86, and reflects a very loyal shareholder base. How many of these fellow travelers of Warren Buffett know that the bank is headed into a massive business model change? Housing has been the leading revenue line item for WFC for years, but government regulation and the naked ambition of American politicians is about to threaten that opportunity. At 1.36x book, WFC is fully valued with the current business. What’s it worth if servicing goes away and mortgage banking is cut in half or more?
The Street has revenue down in 2013, up small in 2014, so the business model change is at least partly priced into the stock, yet earnings are magically up 4x revenue growth. The third theme, of course, in Q1 2013 financials is that earnings growth continues to outpace revenue by a significant multiple. Cost reductions and layoffs are the drivers for bank earnings, but one has to wonder when investors are going to start hitting themselves in the heads with the tips of their skis.
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