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Third Quarter Bank Earnings: 4 Charts

New York | This week in The Institutional Risk Analyst, we look at Q3 earnings for financials from 10,000 feet through four perspectives on four large US banks. If you want a closer look, purchase a copy of The IRA Bank Book for Q3 2019 in our online store.

The Street has continued to retreat from previous estimates of bank earnings made just a few months ago. Some analysts have even figured out that bank earnings will fall for a few quarters. A number of banks have guided down on revenue and Q3 ’19 earnings, but some are actually looking for up volumes in a decidely downbeat market. All that said, the financials are fully invested by Buy Side managers and quite fully valued, but the issue of liquidity still adds a damper to the market narrative.

The liquidity problems which we have discussed over the past several weeks have served as a distraction to investors. Greg Hertrich at Nomura (NMR) put the tactical situation facing banks for the balance of the year into perspective as we head into earnings this week:

“The most recent short-term funding dislocations have been broadly discussed, but the market is still grappling with the overall response by banks to stay ‘on the sidelines’ while markets offered a short-lived earning opportunity… The need for liquidity around mid-September timeframe was amply clear but a number of market participants were caught off-guard by the speed at which the shortfall manifested and that contributed to the paucity of bank response. Banks, by nature, tend to be more methodical and rules-based when it comes to market reactivity. But that’s not the entire story and we think a deeper discussion of banks’ roles is worth the time. There is a lot to unpack here, but as month- and quarter-end periods have the potential to expose weaknesses in the system, it seems rational to expect that spikes like we saw in mid-September are not lost to the sands of time and are likely to be revisited in coming periods.”

Banks are not the only players backing away from big promises made in past days and weeks. The accelerating demise of Libra, the sorta-crypto currency postulated by Facebook (FB) founder Mark Zuckerberg, illustrates the fact that the very smart folks who work outside the banking monopoly in the wonderful world of fintech just don’t get it.

In the US and EU, the world of banking and payments is a carefully guarded market populated by government sponsored entities or GSEs. Recall that Feinberg’s First Law states that no private entity can compete with a GSE. Regulators refer to the large money center depositories as “global systemically important banks,” but they are all GSEs. We call them zombie dance queens because they are destroyers of shareholder value. As Mr. Wonderful said on CNBC this summer: “Dead money.”

To have a hard IP address on the global payments system, like a master account at a Federal Reserve Bank for example, you must be a regulated depository institution. No amount of pretentious talk about “disruption” in the world of payments or “fintech” changes this reality. Governments have a monopoly on money & banking, period.

This is not to say that FB or Lending Club (LC) or SoFi or Quicken can’t enter the world of banking and payments. They can given the right legal and financial advice. But you need to understand the rules of the game. And you need to do the hard work quietly, up front, before putting out the optimistic press release. Count the number of fintechs in the past five years that have talked about a banking strategy of some sort, issued press releases, but then failed miserably.

Whether you looking for a full bank charter a la Warburg Pincus portfolio company Varo Bank, an industrial loan company or even a limited purpose federal trust company, it’s all possible given planning, management focus and purpose. FB, for example, could have approached US and offshore authorities to create a Libra-like token with a full-blown payments solution as part of the offer.

FB might have backed the well-concieved proposal with a commitment to charter an FDIC insured, non-bank trust company to take deposits and make payments. The FB TrustCo would be a member of the Fed regulated by the FDIC. You join the GSE club. Somehow with all that money and all those smart people, nobody thought to suggest same to Mr. Zuckerberg.

Lower Bank Earnings

Over in the world of commercial banks, Q3 2019 earnings loom over a maket where analysts are generally backpedalling away from past prognostications. A number of analysts have actually raised estimates for JPMorgan (JPM), of note, but the bull contingent is thinning out as the number of analysts following the stock declines.

Likewise, with U.S. Bancorp (USB), three quarters of the analysts have a “hold” on the $85 billion market cap stock, which trades a little over 1.8x book value. We own USB but the stock is fully valued given the outlook for the industry.

The chart below shows net income as a percentage of average assets for JPM, USB, Citigroup (C), CapitalOne (COF) and Peer Group 1, which includes the 130 or so US banks with total assets about $10 billion. The first thing to notice is how the 2017 tax legislation increased net income for the industry as a whole, a one- time gift that is now in the rearview mirror so to speak.

Source: FFIEC

Notice too how USB and COF consistently make more net income per dollar of assets than their peers large and small. And C, by comparison, underperforms its peers, one reason why the bank consistently trades below book value in terms of market cap. The Street has Citi’s revenue up small in Q3 but then up 6% in Q4, which never happens. Citi historically is light revenue in Q4 due to seasonal factors.

The biggest negative factor hurting bank earnings in Q3 ’19 is interest expense, something we’ve been talking about since 2017. The good news is that the rate of increase in interest expense for all banks slowed in Q2’19 as the chart below suggests, but observe the huge change in funding costs that has occurred since 2016. Funding costs will continue to increase through the rest of 2019, albeit at a slower rate than the 60-70% annual increases we saw in 2018 and Q1 ’19.

Source: FFIEC

Credit metrics for the US banking industry remain quite strong, but note how much higher are the net credit losses of subprime lenders such as C and COF compared to average of Peer Group 1 or JPM. COF has some of the most aggressive analyst estimates among the top banks and relative high rates of revenue growth.

But again, like C and other subprime lenders, COF tends to trade at a discount to book due to concerns about credit. In 2009, let us recall, COF peaked at almost 10% gross charge-offs vs ~ 2% for the industry as a whole. The chart below shows net loan losses as a percentage of average loans and leases.

Source: FFIEC

Finally, in the chart below we look at gross loan spreads for our sample group and Peer Group 1. As you would expect, the gross yield on loans and leases for subprime COF is 2x that of Peer Group 1. C is about 35% above the average spread for the peer group. It is interesting to note that loan yields for Peer Group 1 have been rising steadily since 2016, but not nearly as fast as funding costs have risen over the same period of time.

Source: FFIEC

Funding cost, at the end of the day, is the single most important headwind facing financials in 2019 and 2020. While the liquidity environment in Q2’19 was reasonably positive for financials, in Q3 the situation changed dramatically. The FOMC has been forced to add massive amounts of short-term liquidity to the money markets. Yet competition for funding has intensified for smaller and midsize institutions away from the largest banks and their captive primary dealer units. We expect to see funding costs continue to rise faster than gross spreads on loans and securities at US banks for the balance of 2019.

The Institutional Risk Analyst publisher Chritopher Whalen is scheduled to discuss Q3’19 bank earnings with Brian Sullivan on CNBC’s “WorldWide Exchange” on Tuesday, October 15th at 5:30 ET.

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