This special guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
Source: Carlos Delgado
Teton Springs | In this issue of The Institutional Risk Analyst, we take a prospective look at Q2 2107 earnings for the large cap banks in the financial services sector. By way of disclosure, we don’t own any banks. Our direct exposure to financials is in fintech and in just two names – Square (NYSE:SQ) and PayPal (NASDAQ:PYPL). More on these names in a future issue of The IRA.
The larger US banks experienced a mini bull rush following the most recent stress tests conducted by the Fed and other prudential regulators. The good news is that the banks have too much capital. The bad news is that, well, the largest banks have too little business to support revenue and earnings, leading to the obvious conclusion that share buybacks must go up.
1. U.S. Bancorp
First, looking at the best valued of the large banks, let’s consider US Bancorp (NYSE:USB). With an “A+” bank stress index rating from Total Bank Solutions, USB is among the lowest risk large banks in the US. Trading at over 2x book value, the shares of the $440 billion total asset USB are up 2x the S&P 500 over the past year. Needless to say, with a beta of 0.93, this is one large bank stock most hedge funds don’t dare sell short.
The Street estimates that USB’s revenue will be up 5% for the full year and earnings up 7% in 2017. Because USB does not depend upon Wall Street investment banking and derivatives activities to make its earnings number, this bank has among the most dependable financial performance of the top five commercial banks by assets.
2. Wells Fargo
Next we move to Wells Fargo (NYSE:WFC), which like USB is primarily a lender with relatively little (but growing) exposure to Wall Street. Like USB, the $1.7 trillion asset WFC has an “A+” bank stress index rating from Total Bank Solutions.
WFC’s equity currently trades a 1.5x book value reflecting the 12% return on equity, but WFC has just a 1% risk-adjusted return on capital (RAROC). The stock has a beta of 1.0, which means that its volatility matches that of the broad market.
The Street has WFC growing revenue at less than 3% for 2017 and earnings up almost 4% for the same period, suggesting that cost-cutting and capital returns will be supporting investor expectations. We tend to discount these projections, however, because of WFC’s huge role in the residential mortgage finance sector.
As we never tire of reminding our readers, the US housing finance sector is running about 30% below last year’s levels in terms of mortgage loan origination volumes. This sharp drop in new loan volumes is translating into an equal drop in issuance of agency mortgage securities. The result is a vicious scramble for collateral that is driving down profitability in the 1-4 family mortgage sector.
Our sources in the mortgage channel say that WFC and JPMorgan Chase (NYSE:JPM) have been bidding up the price of whole loans in the secondary market in order to fill the shrinking mortgage securitization pipeline. The aggressive bid from WFC and other aggregators is killing margins for everyone in the secondary market. This makes us wonder if the resi sector won’t be the cause of an earnings miss for WFC and other large banks in Q2.
Coming off a record low loan origination spread of 8bp in Q1 2017, the mortgage industry faces another difficult quarter. The ten-year average spread compiled by the Mortgage Bankers Association is 51bp, thus the continued drop in profitability has ominous implications for smaller mortgage firms that purchase production from third parties. If you’re a seller of loans, on the other hand, life is pretty good.
Big lending and mortgage servicers such as WFC are desperate to buy collateral from third party originators, both to prop up agency securitization volumes and also to forestall eventual shrinkage in the servicing foot print. Also of note, Fred Small at CompassPoint reckons that this quarter banks and non-banks alike could be facing a 5% downward adjustment in the value of our favorite asset, mortgage servicing rights (MSRs).
3. JPMorgan Chase
Moving right along to the next most valued mega bank, we turn to JPM. Trading at 1.4x book, JPM is fully valued to put it mildly. With lower asset and equity returns than WFC, to see the House of Morgan trading at these levels suggests to us a good bit of downside risk for the shares – regardless of how many managers want to own the stock. JPM has a beta of 1.2, indicating that the equity market valuation is more volatile than the broad market or asset peers such as WFC.
While USB and WFC are predominantly lenders, JPM relies on lending for only about a third of its business. Trading, derivatives and asset management fill out the rest of the bank’s business model footprint – and contribute to earnings volatility. This results in a 0% RAROC for all of the JPM businesses combined vs the nominal 10% equity returns. JPM has an “A” bank stress index rating from Total Bank Solutions.
We fully expect that JPM CEO Jamie Dimon will hit the admittedly low bar set by the Street’s estimates of 2.5% revenue growth for 2017 and 7% earnings expansion, mostly due to further cost cutting. Yet these earnings and revenue figures don’t really support the current equity market valuation for JPM – especially compared with more conservative names such as WFC or USB. Look at the Y-9 performance report for JPM and notice that the bank is consistently in the middle of the large bank peer group compared to WFC and USB which tend to be in the top quartile.
4. Bank of America
Moving from the sublime to the ridiculous, we come to Bank of America (NYSE:BAC), a stock that is up 81% over the past year on the draconian cost cutting by management. And yet even with this amazing upward move, BAC currently trades at just 1x book value -- albeit with a beta of 1.6 or 60% more volatile than WFC or USB.
Even though the Street has BAC growing revenue about 4.5% in 2017 and 2018, and earnings up a whopping 18% this year and 21% in 2018, the stock still does not impress managers enough to earn a premium to book. Perhaps this is because the bank’s earning rebound started from such a low base.
BAC currently has an “A+” bank stress index rating from Total Bank Solutions and, like WFC, derives more than half of revenue and income from traditional banking. The presence of Merrill Lynch in the mix is neutral factor for the organization from a risk perspective, but BAC as a whole does not compare that well to its large bank peers looking at the Y-9 performance report published by federal regulators.
5. Citigroup
Finally we come to the least valued US large bank, Citigroup (NYSE:C), which currently trades at 0.80x book on a beta of 1.6. C has an “A” bank stress index rating from Total Bank Solutions. Like JPM, C’s business model puts equal emphasis on lending, trading and investing activities, resulting in a lower RAROC at 1% vs a nominal equity return of a bit shy of 7%.
Keep in mind that C has lower asset returns and higher credit costs than other large banks, begging the question as to whether the Fed should really be allowing the bank to increase payouts to equity investors. If you look at Page 3 of C’s Y-9 performance report, you’ll see that C’s yield on loans is 2% higher than the large bank peer group, yet the bank has a spread on earning assets half a point lower than other large banks.
The Street has C’s revenue down in Q2 2017 but magically up 1.5% for the full year. Earnings are also expected to be down this quarter, but then will rise an astounding 9.5% for the full year. Despite the market bump following the release of the stress test results, which will result in returning more capital to investors than C actually earns in profits, like BAC the C common still trades at a discount to book.
Unlike names like JPM, C does not have a significant asset management business and also announced an exit from residential mortgage origination and servicing earlier this year. This may turn out to be a blessing in disguise. C is up 58% over the past twelve months vs 13% for the S&P 500, so like JPM we’d say that the risk is on the downside for this much maligned stock.
Will C hit its revenue and earnings numbers for Q2 2017? Probably, especially now that they’ve jettisoned the mortgage business. But the larger question is why does C still exist? In the wake of the 2008 financial crisis, C has been struggling to redefine itself in a way that makes sense to investors.
But having sold the asset management business to Morgan Stanley (NYSE:MS) and the mortgage business to New Residential (NYSE:NRZ) and Cenlar FSB, there is not much left besides the consumer lending book and the payments business. As we’ve noted in previous comments, C’s board ought to consider selling the payments business for a premium price, spin the proceeds to shareholders, then dispose of the other assets for whatever they can get before turning off the lights.
Bottom line is that earnings for the largest banks are likely to be a relatively disappointing exercise given the poor visibility on both earnings and revenue growth. Managers clearly want to own these large cap financials, but a combination of a slowing economy and the Fed’s manipulation of the credit markets is making sustained top line growth elusive.
The Big Picture for Bank Stocks
Longer term, the issue that investors must grapple with in 2017 and beyond is quantifying how much hidden credit risk is embedded in the portfolio of all US banks as a result of the Fed’s aggressive manipulation of the credit markets over the past five years. Corporate credit spreads remain extremely tight. Lurking beneath the currently benign credit metrics, however, lies significant potential losses for both banks and bond investors as an when we revert to the mean.
EDITOR'S NOTE
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the new book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.
