Houston -- Earnings season is upon us and we have a wide selection of low-growth stories for investors to choose from among the largest banks. Why do we say low growth? Well, without the juice from off-balance sheet-financial transactions, and the fictional gains on sale from even more fictional asset securitizations, the large banks are, well, utilities, with single digit equity returns and negative risk adjusted returns on invested capital or RAROCs.
A bank or commercial firm with a negative return on invested capital is, by definition, dead or dying as a business – that is, a zombie from an investor perspective. But that assumes that the investors understand or care about such distinctions. In fact, most Buy Side managers have no idea about the disparate business models of the four largest banks by assets. If you care, then read on.
Let’s go through some of the biggest names in the world of US commercial banks and contrast and compare the Street expectations for these large cap financials. You may want to look at the previous post, “Is the Citigroup Stress Test Rejection Really a Surprise? Really?”
Later this week, we’ll swerve into the unfamiliar realm of “shadow banking.” These non-bank names are actually private companies with private shareholders, whereas the largest commercial banks are effectively government sponsored entities a la Fannie Mae and Freddie Mac.
Regulators and captive members of the academic world like to call private finance companies “shadow banks,” but in reality they are the closest thing we have to private financial institutions in the US economy today. The regulators whine about how they cannot impose prudential regulation on non-banks, but let us recall that the Fed, OCC, FDIC et al let the supposedly regulated commercial banks commit fraud in broad daylight without so much as a protest between 1998 and 2008.
For example, this post on the Fed of New York’s Liberty Street Economics blog refers to “murky finance” in reference to non-banks, yet these same regulators enabled the zombie banks to nearly destroy the global economy during the 2007-2009 subprime meltdown.
Sure, Bear, Stearns, Lehman Brothers and New Century were non-banks, but Countrywide, WaMu and Wachovia were commercial banks. And all of these dead and buried names were playing on the periphery of the big game controlled by the large bank/GSE monopsony.
The FRBNY authors argue that “shadow banks contributed to the crisis through their excessive expansion of credit backed by illiquid assets.” But wasn’t it the banks and GSEs that provided the funding and then sold the toxic assets to investors? Did they notice, for example, that Citigroup just agreed to pay $1.13 billion to settle claims by investors who demanded that it buy back billions in residential mortgage-backed securities?
Who do these folks at the FRBNY think they are kidding? But we digress.
Monday the Wall Street Journal stated that Citigroup may miss its target for return on tangible equity (as opposed to RAROC) after the Federal Reserve Board rejected the bank’s capital plan. Not sure just what is the connection here, since financial results and regulatory capital plans are not even remotely connected.
As we noted in the last post on Zero Hedge, C’s business model is considerably more risky than that of the other TBTF banks, so you can understand why the Fed is being more aggressive. For example, in 2013, C’s losses on loans and leases were almost 4x its large bank asset peers, some 2% vs. just 0.54% for the large bank peer group defined by the Federal Financial Institutions Examination Council (FFIEC). C looks better if you compare it to Capital One Financial (COF), which was also at 2% loan and lease losses vs total portfolio for 2013.
The Street has C at $1.16 for Q1 2014 earnings and $1.22, magically, in Q2. Revenue is just shy of the magic $18 billion per quarter run rate for 2014 but almost touches $20 billion per quarter by 2015 as a result of almost 4% growth YOY. Remember, the curve is always positively sloped on Wall Street. Thus earnings are projected to fall ~9% in 2014 but miraculously grow 9% over the next five years after falling 11% over the past half-decade. OK?
Now, just to reprise our earlier comment, why is the Fed so fixated on C when it comes to capital levels and internal controls? Well, if you look at the most recent Y-9 performance report prepared by the FFIEC, you see that the Tier 1 leverage ratio is 8.4%, in the bottom quintile of the large bank peer group. You see interest expense and dependence upon non-core funding ratios that are some of the worst in the peer group. And you see short term parent debt to equity capital that is 3x the peer group.
But of course, the average Street recommendation on C is a “Buy.” This is the point in the program where Joan McCullough shouts “Next!”
JP Morgan & Co
JPM is trading near its 52-week high, this despite the continued flow of bad news, fines and other regulatory annoyances. The Street has JPM doing $100 billion in revenue in 2014 and 4% growth in the following year. The Street is looking for almost $6 per share in earnings this year and a steady 5% growth rate in 2015. Morgan tends to “surprise” by at least 10% on the EPS line, part of the graceful ballet of Wall Street earnings guidance and actuals made possible by Regulation FD.
Like most large banks, revenue growth is negative in the first half of the year but magically turns to finish in positive territory for full year 2014. Earnings growth estimates for JPM in the first half of 2014 are negative double digits vs the S&P 500, but, again, miraculously turn positive by the end of the year. Like most banks, there is little or no growth on the loan book, with residential mortgages shrinking rapidly vs modest growth in the C&I book.
Of course, JPM passed the Fed’s stress tests, this even though CEO Jamie Dimon has provoked the ire of the senior staff of the central bank for the past several years. But unlike C, the House of Dimon has some of the best regulatory metrics in the business. The Tier 1 leverage ratio of JPM is actually lower than C’s at 7%, but the overall risk profile of JPM is far more pedestrian – at least from the perspective of US regulators, who largely ignore the risk implications of the gigantic OTC derivatives book.
At the end of the day, what the Fed is really worried about is liquidity. Dependence on non-core funding at JPM, for example, is just 9% vs. 34% for the peer group and 63% for C, where offshore and brokered deposits make up a large portion of the funding picture.
Like Countrywide and Washington Mutual before the crisis, C really does not have a firm domestic deposit base to serve as an anchor for its $1.9 trillion balance sheet. By comparison, COF’s net non-core funding dependence is just 12% and the credit card issuer has 10% Tier 1 capital.
The Street has an even stronger “Buy” on JPM than on C, although at 1.12x book value you can argue that JPM is fairly valued. But investors are not buying into JPM for growth. JPM is a good place to hide and collect dividends (2.7%) in a global market where deflation is still the main concern.
Bank of America
BAC has mostly managed to stay out of the news since winning approval of the Countrywide settlement in New York Supreme Court. The stock is near its 52 week high, but at 0.81 x book BAC is fairly valued. The dividend yield of 0.2% is 1/10th that of JPM and for good reason. Revenue is projected to be down in the first half of 2014, up small for the year then miraculously up 4% in 2015. No surprisingly, the average analyst recommendation on BAC is a “Hold.” Those in pursuit of alpha would probably have more fun with C than BAC.
Even though BAC has a lower Tier 1 leverage ratio at 7.86% than C, the bank managed to pass the Fed’s capital stress tests. Net dependence on non-core funding is just 19%. Like JPM, BAC is awash in domestic retail deposits. Even with the burden of Merrill Lynch, BAC has almost half of total assets in loans & leases on a consolidated basis.
Assets at BAC have fallen almost 5% over the past 12 months vs a 2.8% growth rate for the large bank peer group. Loans on 1-4 family mortgages held in portfolio have fallen 18% over the past five years. Loans held for sale have fallen by over 60% over the past five years, one reason why BAC’s former securitization machine is no longer especially profitable. In 2005, let us never forget, Countrywide turned over its balance sheet more than 3x in loan sales.
The BAC common is up 34% over the past year and near the 52 week high, again because the Buy Side wanted to allocate, but on a Beta of almost 2. Like JPM and C, the Street has BAC revenue down small in the first half of 2014, up small for the full year and then up 4% in 2015. Notice that a 4% revenue growth rate in 2015 seems to be really popular with the Street?
With a dividend yield of 2.4%, WFC is like JPM a good place for risk averse investors to hide cash, but the stock is near the 52 week high. Notice how that is a consistent theme with the large banks? There is no value or growth in the sector, but the Buy Side simply allocated to these four names and viola, they went up. At a price to book of 1.68x, you can see the effect of scared money hiding in WFC as with JPM. But the falling revenue and earnings growth rates call that valuation into question.
Like the other large cap banks, the Street has revenue for WFC down single digits in the first half of 2014, up small for the year, then up 4.7% for 2015. Notice that like the other zombies dance queens, the Street has decided that 4 something percent is the right revenue growth number for 2015. What a remarkable coincidence. And the funny thing is that the Street will have to lower the 2015 estimates as the current year nears a close.
Given the truly crappy volume numbers coming from the residential mortgage market and WFC’s leading position in that sector, you’d think that WFC’s forward revenue estimates would be lower than the other zombie dance queens. Black Knight Financial Services mortgage data for February data showed that monthly mortgage originations dropped to the lowest number in at least 14 years, Housing Wire reports.
Real estate loans as well as loans available for sale at WFC are both down sharply from previous periods, yet the Street remains decidedly bullish on this name. Loans on 1-4 family real estate held in portfolio by WFC at $341 billion are at the lowest level in five years.
Given the uncertain outlook for housing, the Street did manage to settle around a “Hold” recommendation for WFC’s common, but really the outlook for housing and the nose bleed book valuation multiple argues for a lower valuation for WFC. With a Beta of 0.86 or less than half that of BAC or C, the idea of a down move in WFC obviously does not have a large constituency.
With a Tier 1 leverage ratio of 9%, WFC has the best capital numbers of the top four banks. It also lacks the broker-dealer that adds to the risk-adjusted profile of the other top four banks in terms of assets. But without the large market position in mortgages, there is no reason for WFC to trade at a premium to JPM at 1.2x book.
Mr. Whalen is the co-author of a new book scheduled for publication in the Second Half of 2014 by John Wiley & Sons: "Financial Stability: Fraud, Confidence & the Wealth of Nations" Click the link below for more information or to be added to the mailing list.