Large Bank Earnings or Why BAC Went to $4

New York -- Writing in the Wall Street Journal, David Reilly opines “Big U.S. banks at least have this going for them: 2012 probably won't be as bad as the year just past.”

Well, maybe. 

First let’s set the stage.  There is a school of thought that says the transit of Bank of America (BAC) common to $4 last month was the final venting of evil humors due to the housing crisis.  Now that the common of BAC is closer to $10 than to $0, the same story goes, the large cap financials are poised for a sustained recovery.

Sad to say, BAC did not trade down to $4 because of a collective epiphany regarding the housing market or large bank exposures to same.  In fact, say a number of sources who trade these markets, BAC nearly touched its belly on the tarmac wheels up because of short selling pressure on EU banks. 

As part of their collective flight from reality, the leaders of the various EU states have banned short selling against EU banks.  Since virtually all large banks in Western Europe have been nationalized, falling prices for bank stocks are the functional equivalent to falling government bond prices.  This merger of bank and sovereign has a nasty implication for the political class in the EU.  Thus short selling against EU banks is not allowed.

With investors no longer able to sell short EU banks, the selling pressure in the markets falls squarely on the large US financials, a few of which have some relatively modest exposure to the EU.  When a New York based hedge fund wants to take a position against the banks in the EU or even UK, hitting the bid on BAC or JPMorgan Chase (JPM) is somehow seen as a worth-while trading strategy.

Thus the noise in many of the stocks for large cap US banks is coming from their insolvent cousins in the EU.  If we could but put aside this noise for a moment and focus merely on the actual financial results for the zombie dance queens, what would be a reasonable expectation?  As with most of 2011, down revenue and record earnings!

Dawn Kopecki and Daikin Campbell at Bloomberg News tell us that “JPMorgan is projected to report a record $18.5 billion in 2011 earnings when adjusted for one-time items, a 6 percent increase for the New York-based company, according to a survey of analysts…” 

Analyst surveys have now risen to the level of fact, as we all know.  Thus Bloomberg and other news outlets feature detailed reports about the opinions of the Sell Side community as though these musings were burned into stone tablets with the fire of the Holy Spirit.

According to the Sell Side community, JPM is expected to bring in record earnings with a 13% decline in revenue for Q4 2011 and a mere 5% drop for the full year.  The same analyst consensus, if we may so dignify this collection of guesses, has 2012 revenue down a mere 1% from 2011.  So while the folks at JPM may be able to manipulate their balance sheet so as to manufacture the “record earnings” so breathlessly described by my friends Kopecki and Campbell, is this really a positive for the stock? 

Speaking with people in the operations side of the top four banks, it is pretty clear to me that there is zero visibility on earnings or revenue in the CSUITEs of the largest banks for 2012.  How analysts are able to estimate full year 2012 earnings for JPM when nobody in that bank knows what will happen in Q1 2012 is really a testament to the intelligence and acumen of the Sell Side analyst community.  

While smaller institutions are starting to stabilize and even grow business volumes, the large cap financials are seeing their Wall Street business shrink even as traditional lines such as mortgage banking and credit cards are flat at best.  The procession of layoffs in areas such a prop trading, investment banking and retail branch personnel tells me that managers are desperate to trim their sails going into a very uncertain year.  And you will see a lot more layoffs in 2012. 

We should recall that the Wall Street side of the universal banks came to the rescue of the commercial banking side of the house in 2008 and each year thereafter.  The supra-normal returns earned by JPM and the surviving dealer banks helped to offset losses on the banking side of the house, but now comes the question: who will pick up the slack now that the party is over on the capital markets side of the business?     
To me, the answer to that question will determine whether Dave Reilly is right about 2012 being better for the large cap financials than 2011.  While I am generally bullish about the prospects for the US banking sector, that happy optimism does not extend to JPM, BAC and their zombie peers. 

The good news is that revenue and earnings are likely to come in lower in 2012 than 2011, hardly a bullish factor for these respective stocks.  But the bad news is that BAC and, to a lesser degree, Wells Fargo (WFC) remain mired in problems related to housing exposures and related litigation.  Neither one of these banks is doing an especially good job with disclosure regarding these risk factors, so investors are basically on their own. 

Suffice to say that when you see 1) Ally Financial file bankruptcy and 2) Bank of New York Mellon (BK) finally break the alliance of convenience with BAC and sue the large bank of behalf of RMBS investors, then you will know that we are getting closer to the end of this horror film than the beginning.