3 Big Risks Hidden in Banks’ Earnings Beats

3 Big Risks Hidden in Banks’ Earnings Beats

iStockphoto/The Fiscal Times

“Yes, but….” 

That’s the only way to react to the news that JPMorgan Chase (NYSE: JPM) and Wells Fargo (NYSE: WFC) reported record earnings results late last week, trouncing analysts’ expectations and posting bottom-line gains of 31 percent and 19 percent, respectively, for the second quarter of the year.

Just looking at those numbers, investors may feel tempted to celebrate by snapping up bank stocks. But you might want to hit the “pause” button here. Both stocks have gained about 25 percent so far this year, handily outperforming the S&P 500 (ahead 17.8 percent), so arguably at least some of this outperformance already has been priced into the share prices. And while the shares might look relatively inexpensive (JPMorgan trades at just over 9 times trailing earnings; Wells Fargo at 11.5 times trailing 12-month earnings), returns on equity for the industry are still relatively meager.

Overall, the industry’s collective wisdom is that given the current cost of capital, an ROE north of 12 percent is pretty much required for a bank to be an appealing investment. Both meet that test, but only just: JPMorgan Chase, for instance, announced its ROE was 13 percent for the second quarter. That’s better than the 11 percent reported last year, but still underwhelming.

This is where two big caveats enter the picture. Both have to do with the bank’s earnings (let’s focus on JPMorgan Chase for now, as representative of the industry), one of which is forward looking and one of which refers solely to how the bank generated its profits for the quarter.

On the latter front, it’s notable that some of JPMorgan’s big earnings beat came from the fact that the bank was able to release $1.39 billion of loan loss provisions, a non-cash gain made possible because its actual losses weren’t as bad as had been feared. Yes, that’s good news – but it also means that some of the bank’s positive surprise had nothing to do with how well its operations fared during the quarter.

The other factor? That has to do with mortgage banking, a big source of both revenues and profits for most financial institutions. In the headlines of their earnings release, JP Morgan Chase emphasized that mortgage originations rose 12 percent over year-earlier levels to hit $49 billion, but lower down, the bank noted that this was 7 percent below the first quarter. And the picture for JPMorgan’s mortgage banking group wasn’t all that appealing: Net income fell 14 percent; net revenues fell 15.1 percent; net interest income dipped 7 percent and non-interest revenue tumbled 19.7 percent, thanks to what the bank described as lower mortgage fees.

Even before interest rates started to rise last month, some bank analysts were already starting to worry how the mortgage origination and refinancing engine would continue to generate profits for the banks. Without rates low enough to give homeowners incentive to keep refinancing, and without a big (read: more significant than we’re seeing) surge in new home sales, it’s hard for JPMorgan and Wells Fargo to keep doing better. (Between them, the two banks account for about half of all residential mortgages written in the United States.)

The prospect of higher rates adds an extra headwind to the outlook. When interest rates rise, the demand for refinancing tapers off significantly: Who, after all, willingly swaps a lower rate for a higher rate? And refi activity accounts for more than half of all new mortgage loans at Wells Fargo and a significant chunk of activity at JPMorgan as well. As Marianne Lake, CFO of JPMorgan, told listeners on the bank’s conference call last week, the upward pressure on interest rates “could have a significant impact” on refinancing – perhaps cutting the market by “an estimated 30 percent to 40 percent.”

Needless to say – though Lake said it anyway – “this would be a significant event.” Theoretically, the banks could turn to net interest margin – a measure of their ability to profit from the spread between the rates at which they lend and borrow – to compensate for some downturn in volume, but so far that has proven tough.

In this atmosphere of uncertainty, it’s worth waiting to see what the other big banks have to say when they release their own results this week. By the time you read this, Citigroup (NYSE: C) will have published its results: The market was anticipating a 17 percent jump in earnings to $1.17 a share. Tuesday is Goldman Sachs (NYSE: GS) day, and will offer a more focused look on investment banking and capital markets operations. Goldman doesn’t dabble in the consumer banking arena. Then on Wednesday, it is Bank of America’s (NYSE: BAC) turn, and investors will be watching to see whether the bottom line results help offset the risk associated with all the litigation costs it has had to deal with as a result of the financial crisis.

The banks’ results are likely to provide more questions than answers. Will they be able to ramp up mortgage lending volumes and offset the lack of refinancing income that way? Will they adjust their lending standards in response, and will this have an impact on risk levels? How well will they manage the spread between their cost of capital and their lending rates?

The good news for investors, however, is that all of these fall into the category of known risks. This is the kind of cycle that bank CEOs know to prepare for, and that they have been anticipating for several years. Coping with a shift in interest rate policy on the part of the Fed is what banks know how to do, or should know how to do.

There is one more cloud drifting overhead, though. While it isn’t particularly menacing at present – and may never represent a real threat – the prospect of tougher new regulations shouldn’t be overlooked. Newbie Sen. Elizabeth Warren (D-MA, who happens to be a veteran crusader for financial market reform) and veteran Sen. John McCain (R-AZ) are working as part of a bipartisan group to introduce a bill that they hope will lead to a break-up of the biggest banks – a revival of the Depression-era Glass-Steagall Act that was repealed in 1999. Given that implementation of the Dodd-Frank reforms has proved sluggish, to put it mildly, the odds that the senatorial group will win enough support to push another financial reform bill through not only their own body but also the sharply divided House of Representatives are slim indeed.

That doesn’t mean, however, that the banks won’t come under tougher scrutiny by both lawmakers and regulators in the coming months. That’s good news for lawyers; bad news for banks. So if you feel tempted to join in the jubilation, remember that this week’s crop of bank earnings represents what has happened, but what will shape stock prices in the coming days and weeks is what investors think or fear may happen next.