Two U.S. Treasury secretaries and Federal Reserve Chairman Ben S. Bernanke provided capital and cheap loans to banks during the last three years to help fuel an economic revival. It hasn’t worked out.
While those policies benefited Wall Street, they failed to produce a sustained recovery on Main Street, where unemployment remains more than 9 percent. Now the sputtering U.S. economy may sap bank earnings and Wall Street bonuses.
Profit estimates for companies including Bank of America Corp. have been slashed as much as 30 percent following a report showing weaker-than-expected growth in first-half gross domestic product and after the Federal Reserve said it plans to leave benchmark borrowing costs at historic lows for two years. The 24-member KBW Bank Index has dropped 21 percent since July 28, the day before the latest GDP figures were reported, compared with an 11 percent decline in the Standard & Poor’s 500 Index.
“The political class is fixated on how the banking system caused the problem in the first place and therefore how it will have to cure it in the future -- that if you get the banks working again the economy works,” said Robert B. Albertson, chief strategist at Sandler O’Neill & Partners LP in New York. “It drives me into silly laughter. It’s the other way around.”
Combined first-half earnings at the 15 largest U.S. banks by assets dropped 17 percent from a year earlier, led by a decline at four of the six biggest. While the average estimates of analysts surveyed by Bloomberg show they still expect second-half earnings at the 15 lenders to climb 88 percent from the same period in 2010, stock prices trading below book value at 12 of those firms indicate investors aren’t so sure.
“I don’t think economic reality has hit estimates yet,” said Matthew D. McCormick, a portfolio manager at Cincinnati- based Bahl & Gaynor Inc. who helps manage about $4 billion and doesn’t own the biggest U.S. bank stocks. “Trading revenues are abysmal, and you’re looking at net-interest-margin compression,” he said. “I’ve got to believe that this is going to be a tough quarter.”
Bank of America, the largest U.S. bank by assets, has dropped 53 percent in New York Stock Exchange composite trading this year and closed yesterday at $6.30, or 31 percent of the bank’s book value per share at the end of June. JPMorgan Chase & Co., the second-biggest bank, has fallen 18 percent to $34.78, compared with a book value per share of $44.77 in June.
“We reiterate our ‘negative’ outlook on the sector due to poor visibility on new loan volumes, revenue and earnings, as well as continued Fed zero interest rate policy,” Christopher Whalen, a former Federal Reserve Bank of New York analyst and co-founder of Institutional Risk Analytics in Torrance, California, said in an Aug. 19 note to investors.
The banking system and the economy might be in worse shape if it weren’t for the policies of Bernanke, former U.S. Treasury Secretary Henry M. Paulson and his successor Timothy F. Geithner. The Fed provided as much as $1.2 trillion in loans to banks and other companies beginning in August 2007, slashed its main U.S. interest rate as low as zero in December 2008 and has engaged in two rounds of purchasing bonds in what’s known as quantitative easing. In October 2008, Treasury began injecting equity capital into banks by purchasing preferred stock.
U.S. banks are better prepared to withstand a crisis than in 2008 because of the capital and liquid assets they’ve accumulated, according to analysts including Richard Ramsden at Goldman Sachs Group Inc. in New York.
“Capital levels are at historic highs, funding mixes are much improved, and leveraged losses have already been largely written off,” Ramsden and his team wrote in an Aug. 11 note to investors. “The risk to bank earnings from here therefore appears to be more about an extended low-rate, low-growth environment.”
U.S. GDP grew at a 1.3 percent annual rate in the second quarter, less than the 1.8 percent average forecast of economists surveyed by Bloomberg News, and 0.4 percent in the first quarter, the Commerce Department reported July 29.
Eleven days later, the Federal Open Market Committee said it “now expects a somewhat slower pace of recovery over coming quarters” and that “downside risks to the economic outlook have increased.” These conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013,” the FOMC said on Aug. 9.
‘Negative Feedback Loop’
The U.S. and Europe are “dangerously close to recession,” Morgan Stanley analysts including Chetan Ahya said in a note to investors on Aug. 18. “A negative feedback loop between weak growth and soggy asset markets now appears to be in the making in Europe and the U.S.”
Feeble economic growth has reduced demand for loans from consumers and businesses, and low interest rates are compressing profit banks can reap from credit they make available.
“Interest rates at these levels basically squash your deposits and funding costs to a floor that it can’t go through while your yield on assets such as securities and loans get pushed down even further and so you get a margin squeeze,” said Sandler O’Neill’s Albertson. “Rates are too low, and the economy’s too weak.”
Net interest income, the difference between what banks pay to borrow and charge to lend, accounted for 54 percent of the combined revenue at Bank of America, JPMorgan Chase, Citigroup Inc. and Wells Fargo & Co., the four biggest U.S. banks by assets, in the first half of this year.
‘Taking Market Share’
“Right now, if there is a bank that’s successful it’s more that they’ve been taking market share away from their peers,” said Peter Kovalski, a portfolio manager and bank industry analyst at Alpine Woods Capital Investors LLC in Purchase, New York, who manages about $6 billion. “The overall pie hasn’t increased yet. We need to see some sustained economic growth before that happens.”
Kovalski said he’s steering clear of the biggest U.S. banks and instead owns stock in smaller lenders such as Atlanta-based SunTrust Banks Inc. and Cleveland-based KeyCorp that he says have better growth prospects and trade at lower valuations.
The day after the Fed’s statement, Deutsche Bank AG analysts, led by Matt O’Connor, said in a report to investors that the weaker economic outlook and rate environment meant estimates for banks’ earnings per share may need to be lowered by as much as 30 percent. Analysts at Goldman Sachs, International Strategy & Investment Group Inc. and London-based Atlantic Equities LLP followed with their own reductions.
“Meaningful loan growth is likely to remain challenged for the majority of banks absent any material market share gains,” Ramsden’s team wrote on Aug. 11. Bank net interest margins “are unlikely to be able to rise as lower yielding assets become a larger part of the total book and funding costs reach a floor.”
ISI’s Edward Najarian, in an Aug. 12 note, said he expects “banks will remain in a revenue recession” and cut his second-half earnings-per-share forecasts for 10 banks by a median 7 percent. Richard Staite, an analyst at Atlantic Equities in London, trimmed his 2012 revenue estimates by as little as 1.3 percent for Citigroup and as much as 3.5 percent for Bank of America in an Aug. 17 note.
In its quarterly banking profile yesterday, the Federal Deposit Insurance Corp. said that second-quarter earnings at 7,513 insured institutions posted a year-on-year increase for the eighth consecutive quarter. The rise stemmed from a drop in provisions for loan losses; net operating revenue was lower than a year ago for the second quarter in a row, the FDIC said.
Revenue at the biggest banks is unlikely to be boosted by their Wall Street activities. Fixed-income trading, which fueled 2009 revenue growth at the four largest U.S. banks as well as Goldman Sachs and Morgan Stanley, has been weaker in the last year. First-half investment-banking and trading revenue declined to $91 billion at the top 10 global banks from $93 billion a year earlier, according to an Aug. 16 report from industry consultant Coalition Ltd.
Banks’ revenue from trading stocks and bonds will probably be 8 percent to 10 percent lower this year than forecast because of the dimmer growth outlook and declines in interest rates and stock markets, estimated ISI’s Najarian.
Trading-desk profitability also has been hurt by regulators’ demands that lenders hold more capital and by rules imposed by the Dodd-Frank Act, Ralph Schlosstein, chief executive officer at New York-based investment bank Evercore Partners Inc., said in an Aug. 11 interview with Bloomberg television. The changes mean traders can’t earn as much profit as they used to for each dollar of equity capital, he said.
“Step one is going to be an attempt on the institutions’ part to redraw the line between the employees and the shareholders to try to bring that return on equity back up,” Schlosstein said. “It will be done first by headcount reductions and second, I suspect, it will also have an impact on compensation in those firms as well.”
Coalition’s report estimates that the largest Wall Street firms will cut about 5 percent of their revenue-producing employees in the second half of the year. The 50 biggest banks, including HSBC Holdings Plc, Credit Suisse Group AG and Bank of America, announced almost 60,000 job cuts through the first week of August, according to company statements and data compiled by Bloomberg Industries.
UBS AG, Switzerland’s biggest bank, said yesterday that it will cut about 3,500 jobs, or 5.3 percent of its workforce, to reduce expenses. Bank of America CEO Brian T. Moynihan said in a memo to senior managers on Aug. 19 that the Charlotte, North Carolina-based bank will eliminate about 3,500 jobs this quarter in addition to 2,500 cuts made earlier in the year.
“While the markets reflect many economic factors we cannot control, we must stay focused on what we can control,” Moynihan, 51, said in the memo.
Year-end bonuses for fixed-income traders and salespeople across Wall Street are likely to fall 20 percent to 30 percent from last year, Johnson Associates Inc., a New York-based compensation consulting firm, estimated on Aug. 12.
Even though he cut his estimate for JPMorgan’s 2012 revenue by 2.4 percent, Atlantic Equities’ Staite raised his recommendation on the stock to “overweight” because he thinks the second-biggest U.S. bank by assets has an opportunity to win market share, especially against European banks that may pull back because of that region’s sovereign debt crisis.
“JPMorgan’s still on the front foot, they grew their market share during the crisis, and that will continue for the foreseeable future, or at least for as long as we have continuing uncertainties in Europe,” Staite said in a telephone interview. Even in the U.S. “they have a program to open 2,000 new branches, so you’re seeing them expand across all of their business lines.”
JPMorgan, unlike rivals Bank of America and Goldman Sachs, hasn’t announced plans to cut jobs. The average estimate of 21 analysts surveyed by Bloomberg is for the New York-based bank to report record profit of $20.8 billion this year.
JPMorgan is sticking by its European clients and hopes to benefit from that, Chairman and CEO Jamie Dimon, 55, told analysts on July 14.
“Our current thinking is that we’re going to continue to do business there and manage those exposures,” he said. “We’re not trying to drive them down. And I hope that one day some of these European nations appreciate the fact we’re not cutting and running.”
Citigroup, the third-biggest bank by assets, will also be less affected than rivals by the U.S. economy, Staite said. Citigroup CEO Vikram S. Pandit, 54, has said the New York-based bank derives more than half its ongoing profit, which excludes businesses tagged for sale or closure, from emerging markets.
European banks “will maybe rein in some of their growth ambitions for Asia, and Citigroup, which already has a strong business in these areas, will hold on to their market share,” Staite said. “I still see emerging markets as a positive story for Citigroup.”
‘Chicken and Egg’
Most bank stock prices have fallen further than even the gloomier earnings outlooks warrant, said Sandler O’Neill’s Albertson. They’re also failing to factor in the potential for market-share gains and the possibility that banks start to make some of the real estate and consumer loans that had become the purview of the so-called shadow banking system in recent years.
Still, investors will need to continue to look at the economy itself for signs that banks’ prospects are really brightening, Albertson said.
“Lending does not create economic growth,” he said. “Economic growth creates lending. It’s not a chicken and egg. You can tell what the lead is. The lead is the growth itself -- the growth in incomes and earnings from individuals and companies that allow them to take more debt to buy more or invest more.”