The Sustainability of Big Bank Earnings

Investment banking and declining delinquencies helped power strong results for J.P. Morgan and B of A, but uncertainty in the housing market and broader economy still loom, says Morningstar's Jaime Peters.

The Sustainability of Big Bank Earnings Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com with J.P. Morgan and Bank of America kicking off big bank earnings this week. I'm here with senior bank analyst Jamie Peters to talk about the results and to see what the future might hold for these companies. Jamie, thank you for joining me today. Jamie Peters: Good morning. Jeremy Glaser: One of the things that struck me about these earnings releases is that the investment bank results really seem to be driving earnings. Is this something that you've seen over the past couple quarters or something that you think is sustainable over the long run? Jamie Peters: Well, investment banking results last year were actually quite exceptionally high because of widespread and favorable conditions in the fixed-income market. We had expected them to start to come back down, but what is happening is that there is such activity in fixed-income right now that the banks are still posting very, very good numbers. First quarter is always a seasonably high quarter, so as a result we do expect returns to come down over the year, but they're still performing much better than we expected. Jeremy Glaser: Do you think this is something that investment banks can keep doing well over time or do you think there will be a reversion back to the mean where this kind of out performance is going to disappear? Jamie Peters: In part, well disappear as the fixed-income market starts to settle down a little bit more. Credit spreads have already come in quite a bit. It's simply the level of activity right now that is so high. As that starts to calm down a little bit as well and we don't have places like Greece having crises, then we will see revenues come down as well. Jeremy Glaser: Moving to the other side of the business, what's happening with charge-off rates and with delinquency rates on the loans made to consumers and businesses? Jamie Peters: It's an interesting story. We're having J.P. Morgan, Bank of America actually showing fairly decent numbers in early delinquency buckets. That means that new people aren't getting behind on their loans quite as much. However, we saw a different story as far as charge-offs. They're really still quite high compared to historical levels. They're going to remain high. We saw J.P. Morgan's should come down a little bit. We saw Bank of America's go up a little bit. That was mainly a result of them changing how they recognize charge-offs, though. The reality is that things are really starting to stabilize. Now that could be temporary and the two companies took very different attitudes towards it. Bank of America seemed to be pretty happy and thinking that things are probably going to continue to get better, whereas J.P. Morgan was a little bit more cautious. They were suggesting that the improvements in the housing market simply could simply be transient that we have a lot of things coming up. We have an $8,000.00 homebuyer's credit. We have interest rates at a current year low that could start increasing. Any of these things could destabilize the housing market. We could start seeing home prices fall again. And as a result, we'd see loan loses go up again. Both companies are going to be fairly damaged if their earnings are going to keep hurting if that happened. So they're in a different sort of attitude. Bank of America a little more aggressive, J.P. Morgan a little more conservative but that's because J.P. Morgan can afford to be a little more conservative. It winds up being a fairly good story right now, but it's one that could change on a dime. Jeremy Glaser: Over the last two years, we've seen the banks contract their lending. Do you think that's a function of that there just isn't demand out there for loans right now or do you think that the banks are really trying to shrink their books? Jamie Peters: It's actually a combination of both. What's going on is that customers who are not credit-worthy, who probably should not have gotten a loan in the first place when we had the big bubble run-up are not finding loans. But customers who are credit worthy are finding loans right now. What's happening is that, especially on the commercial side where you've seen the most contraction, businesses are not hiring, they are not building inventory. And as a result, they do not need new loans, so you're seeing the books come down a little bit. Banks are kind of iffy on what's going to happen, when it's going to turn. They're hoping by the end of the year especially if the economy continues to recover that we might see stabilization in unemployment, and potentially see new hiring as well as inventory builds which would help them reverse that trend on their loan books. Jeremy Glaser: Financial regulatory reform is another big topic on a lot of people's minds if they're invested in these banks. How are they dealing with the uncertainty that they're not sure what any legislation would eventually look like? Jamie Peters: You know it's very interesting. Some of them are very reluctant to comment on it especially individual portions of it because we're not sure where it's going to fall out. As a result of that uncertainty, what they are doing is they're being conservative on the capital side. Bank of America, J.P. Morgan, they earned quite a bit more than their penny and nickel quarterly dividends. But they are not going to raise those dividends until they have a good sense from the government what's going to happen with all those three. What are the regulations going to be? Where are the minimum capital levels going to be? Until we find out those types of answers, we're going to expect that these companies are going to retain their earnings because the last things they want to do is start raising their dividends, paying out the capital, and then discover six months to 12 months down the line that they're going to fall short and they're going to have to raise capital. It's cheaper to retain than to pay out and then try to get it back. Jeremy Glaser: So what do you think about the valuation levels of these stocks right now? Jamie Peters: Both companies are actually slightly undervalued. They're not exceptionally undervalued. We aren't in last March where they were trading for pennies on the dollar of what they're worth in the long run. What we do have right now is a slight discount to our current fair values. That might continue to go on or it might start closing the gap if people start getting a little more confident in the recovery of the economy. But people are still going to be cautious and there are still quite a wide variety of options that could happen to these banks earnings because we do not know if the housing market is going to stay stable. We do not know if unemployment is going to start to improve. As a result, what could happen by the fourth quarter of this year, the range could be up 100% or could be down 50%. Jeremy Glaser: All right. Jamie thanks so much for talking to me today. Jamie Peters: Thank you. Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser.