Big Bank Earnings: There's More To It Than You Think This Quarter

Three of the nation's biggest banks kicked off first-quarter earnings season last week. The results were generally positive, withJPMorgan Chase(NYSE: JPM) andCitigroup(NYSE: C) both reporting double-digit bottom-line increases compared to the year-ago quarter. The exception wasWells Fargo(NYSE: WFC), which uncharacteristically reported a year-over-year decline in its quarterly profit.

Listen in to this week's episode of Industry Focus: Financials, where The Motley Fool's Gaby Lapera and John Maxfield dig into the details behind these performances.

A full transcript follows the video.

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This video was recorded on April 17, 2017.

Gaby Lapera: Hello, everyone!Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition,taped today on Monday,April 17, 2017. My name is Gaby Lapera, and joining me on Skype isJohn Maxfield, our bankingexpert extraordinaire. How's it going, John?

John Maxfield: [laughs]I love that introduction, butI think it's probably over billing me. But it's going great, thank you!

Lapera: I'm really glad to hear that. Listeners,I'm really sorry, you might hear me take some extra big deep breathsduring this podcast. I had some kind of adverse reaction to amedication, and I think it gave me a touch of asthma. So,sorry in advance about that. Today, we'regoing to be talking about what else but first-quarter banking results. Aren'tyou excited? I know I am! How about you, Maxfield?

Maxfield: Snoozer.[laughs] No,that's not true. We'regoing to talk about some interesting things. So even though, in general, it could be a conversationthat could be really boring,I think there's some interesting stuff that listeners will pick up from this.

Lapera: Oh, no, we bring thepizzazz.

Maxfield: [laughs] Youbring the pizzazz,I bring the boring. You're here, Gaby.

Lapera: [laughs] So far,JPMorgan,Citi, andWells have all reported. Bottom lines for JPMorgan and Citi look good.

Maxfield: Yeah,both of them were up 17% on a year-over-year basis. When you're talking the biggest banks in the country, and among the biggest banks in the world,it's not often that you're going to see earnings grow by double-digitpercentages on a year-over-year basis.

Lapera: Yeah,that's pretty exciting. We weretalking a little bit before the show, and it looks likeit's mostly driven through their trading and investment banking. All these big banks, well, Wells kind of, but JPMorgan and Citi especially are universal banks. That means they have twoseparate arms. They have their retail arm, wherethey're doing what you traditionally think of as a bank's business, likegiving out loansand collecting interest and doing whatever it is that big banks do. The other side of it is this investment-banking side. That's where they saw the big gains this quarter.

Maxfield: Yeah. If youthink about where we wereat this point last year -- andI want to say,I'm going to be totally selfish here,but there's a part of me that wishes we were where we were atthis point last year, because that's where, as an investor, we had gone through a huge correction in the market, and as an investor,that's the absolute best time to be in. Right now,everything looks so expensive, so I'm thinking back so fondly on those days. But if you think back to the first quarter of last year, which is what the banks were comping againstin the first quarter of this year, there were two things in particular that really helped those comps shine. The first is that oil prices dipped below $30 a barrel. They got down to around $25 a barrel. And that is really, really low. Theproblem with that for banks --even though it's great for consumers -- is thatif you lend money to energy companies andthe price of oil goes down that far, some of those companies that areoperating with really tightened marginsaren't going to be able to service their loans. So that made banks increase their loan-lossprovisions in anticipation offuture loan losses from the energy industry.Oil prices have since been on the mend. So they didn't have that concern this year, so they were able to scale down their provisions. Provisions act on incomein the same way that expenses do. So it just freed up a whole bunch of revenue to fall to the bottom line.

The second point,to the point that you're making, Gaby, is that there is alsoin that first quarter is when the United Kingdomannounced that it was going to have a referendum on whether or notit would stay in the European Union. Now, that actual votedidn't happen until later in the year,but that announcement,in addition to concerns about slowing economic growth in China, caused anenormous amount of volatility in thevarious types of capital markets, and that translated into lower trading revenues for banks. What banks are is, they helpinstitutional investors buy and sell securities, but wheneverything's going crazy in the market, thoseinstitutional investors step back, which reduces the commission that large, universal banks make from them.

Lapera: Yeah,everyone was kind of in a tizzyat the end of the first quarter of last year.I remember that.I was looking at the show notes from last year around this time, and I was like, "Oh, yeah,I remember." We actually got a listener question aboutwhat was going on and we answered it and everything. Times were different then, a whole year ago. But the point that you're making, Maxfield, I think, is thatthe hurdle, the bar, is low for these banks to succeed year over year, in terms of2016's first quarter versus 2017's first quarter, right?

Maxfield: That'sexactly right. Now,I don't want to be unfair,because JPMorgan Chase,even though, there was aneasy comparisonin terms of the comps this year compared to last year, itstill had a really good quarter. Even in this reallydifficult and inhospitable environment for banks, it's earning a double-digit return on equity. So let's be fair; it had a good quarter. But it wasn't as amazing as it looks, based on those comps.

Lapera: Yeah, totally fair. So,even though JPMorgan and Citi did generally well, Citi'snet interest margin went down. Can youtalk a little bit about that?

Maxfield: Yeah,and I'm really glad you brought that up. One of thenarratives in the banking industry right now is that banks are going to earn a lot more money as interest ratescontinue to go up. Since the financial crisis, interest rates have been really low. But inDecember of 2015,the Federal Reserve increased interest rates by 25 basis points. Theydid so again in December of last year and did so again one more time in March of this year. When interest rates go up, that means it costs more to borrow. Andbecause theprincipal product thatcommercial banks in particular sell are loans,if the prices of those loans go up, thattranslates into higher revenue. What we're seeing with Citigroup, and we'regoing to see a lot of that withBank of America(NYSE: BAC) when it reports earnings tomorrow and throughout the year, because it's come out and said, "Look, on a quarterly basis, just because of that 25 basis points," that's a 0.25%increase in the Fed funds rate,which is the rate that banks lend money,the reserves that are held atthe Federal Reserve,if they have excess reserves held there, they lend those reserves out on an overnight basis to other banks that need more liquidity. So as that has gone up,Bank of America is going to make all this additional money. Buthere's the thing. In Citigroup's case, andJPMorgan Chase is seeing the same thing, and other banks are expected to see that, too, but Citigroup didn't see that,and the reason is because it is still dealing with a lot of churn on its balance sheet related to toxicassets that dateback to the financial crisis. So there's all this other noise in the numbers that isdisguising the positive impact ofhigher interest rates on Citigroup's bottom line.

Lapera: Yeah. I will say, it's 2017, it's been a while. You would thinkthey would have sorted through this a little bit quicker, andI think that speaks tothe complex structure that Citibank has,that it's so difficult for them to unload these assets,with the regulations on them. But hopefully we see a little bit more hustle on that.

Maxfield: It also speaks to themagnitude of the issues that Citiran into in the financial crisis. It has taken a long time to work through these things. Theother bank that had a similar thing was Bank of America, and itreally didn't turn the corner until two years ago. So Citigroup is just a little behind it, but iteventually will turn the corner,and you'll see that in the bottom-line numbers.

Lapera: Yeah,eventually,one day, hopefully.[laughs]Theother bank I wanted to talk about is whatused to be America's sweetheart of a bank,which is Wells Fargo. They'reprobably going to be the only big bank to see its earnings decline on a year-over-year basis. Do you think that'srelated to the account scandal?

Maxfield: I think that it is. Michael Douglass, who is aneditor at The Motley Fool,he describes Wells Fargo as "the fallen angel," and I think that'sthe perfect way to describe it. If you go back 150 years,Wells Fargo has one of the best reputations, andone of the best brands in the bank industry in the United States for a long, long time -- back since theGold Rush in the late 1840s and 1850s, when it was established. Butbecause of that fake-account scandal that wasrevealed last September --thousands of Wells Fargo employees, in an effort to meet sales quotas,in terms of selling additional credit cards, sellingadditional checking accounts, selling additional savings accounts, theyopened up fake accounts for customers thatcustomers either didn't need, didn't approve of,or didn't even know were being opened. So that has really tarnished Wells Fargo's reputation. Andif you look at Wells Fargo's numbers from the most recent quarter,it isn't strikingly obvious. It isn't like the revenue fell by 10% as a result of this, or their expenses went up by 20%. It's a much more marginal impact. But what we're seeing is a continued erosion in a number of keymetrics at Wells Fargo. The efficiency ratio is a perfect example. It has long been one of the most efficient banks in the country. Butbecause ofpotential revenue pressureas a result of what happened,the reputational damage it suffered, and that salesscandal last year,combined with the potential that they're going to have to increase their compliance costs, theirregulatory costs to deal with that, it's slowly eroding its bottom line at this point.

Lapera: Yeah. Andthat's something you're just going to have to look out for long-term. The thing withWells Fargo is that basically all things have been held equalexcept for the reputational damagethat we mentioned from the account scandal. As a result of the account scandal, they changedsome of their internal practices for selling, as one mightexpect, toencourage their employees to stop creating thesefraudulent accounts, which means thatsome of their numbers don't look as good anymore for account openings. Because there's fewerfraudulent accounts. So when you throw all that into the mix, we'll seewhether or not Wells Fargo pulls out of it. It'snot quite a nosedive yet, but it'sdefinitely something to keep your eye on.

Maxfield: To that point, Gaby,if you listen to Wells Fargo's executivesprior to the crisis, for years, they stressed the cross-sell ratio. That is thenumber of financial products -- so,checking accounts,credit cards, mortgages,all those types of financial products and services -- thenumber of those that the average customer at Wells Fargo used. And they always trended 2 times, 3 times theindustry average in terms of thenumber of products that each of their customers used. Then, if you listened to the way their executives talk about getting those large cross-sell numbers, what they would do isgo after primary checking accounts for a customer,which is the principal banking product,and then build on top of that -- and now, we're seeing new checking accountnumbers falling on a year-over-year basis by 30%, 40%, newcredit card applications at Wells Fargo falling by 40%-plus on a year over year basis -- in the short term, that'snot going to have a big impact on their numbers. Because it's not like a bankmakes a whole bunch of money when acredit card application is submitted, or any money, quite frankly, or when a new checking account is opened. But it's thatdeepening of the relationship where the profitability comes from. So the question is, when theyannounced that they were getting rid of their sales quotas in their branches as a result of the scandal,what is that going to look likeover the long term for Wells Fargo, given that its model has beenpredicated on cross-selling for all of these years?

Lapera: Yeah,definitely. It's an interesting story, and one that we will definitely continue to cover on Industry Focus. One bank that you might notice ismissing is Bank of America. That's because they don't report until tomorrow. Overall,I'm kind of expecting to see the same thing going on with Bank of Americaas you saw with JPMorgan. In fact, they might even do better,because their profitability is so tied to interest rates. And you've talked about before,a little bit of an increase in interest rates means $X billion more of Bank of America.

Maxfield: Yeah.I think that Bank of America is in a stretchright now, where every quarteryou're just going to see tangible improvements, andtangible improvements, and tangible improvements. I'mvery optimistic,if it wasn't clear, about Bank of America. The one thing I would say, however, that investors should bethinking about with Bank of America and other banks right now, isnot so much about their fundamental performance. We weretalking about this before the show, Gaby,I don't think that's what's driving their stocks right now.I think what's driving their stocksright now is expectations around policy. When you'relistening to the fact thatBank of America is going to have this greatfundamental quarter,they seem to be primed for this greatfundamental quarter,I would not interpret that, as an investor, to mean that its stock isnecessarily going to shoot up after itannounces results tomorrow.

Lapera: Yeah, andI definitely want to get into that thing that you alluded to about fundamentals versus policy.

Wecovered that the first quarter of last year was pretty terrible for banks, so the year-over-year growthlooks phenomenal. But there's some otherstuff going on with bank stocks. If you've been following the banking sector for at least the last four or five months, you might have noticed that there wassomething that is nowaffectionately called the Trump bump, which was rightafter the election, bank stocks took off. And that's not acoincidence,because one of the things that Trump talked abouton the campaign trail over and over again wasderegulation and allowing more freedom for the banks. And people drove bank stocks up on the assumption that this regulation was,especially Dodd-Frank, that's reallywhat we're talking about when we say regulation, that that was going to be repealed orchanged in such a way that banks would have more freedom, andthey were going to be able to drive up their profits.

Maxfield: Yeah. So, what we saw in the election is, bank stocks went up 20%-30%almost immediately. Theelection happened in November,earnings didn't come out until the middle or beginning of October, and then theFederal Reserve raised rates in December, and thenearnings for the fourth quarter didn't come outuntil January. So there were no fundamental catalysts -- and when I sayfundamental catalysts, I mean there was nothing company-specific. It's not like a company came out and said, "Wequadrupled our earnings on a year-over-year basis," and everybody thought, "Oh,all banks are going toquadrupletheir earnings on a year-over-year basis." It was that you had thisexpectation fueled rally in bank stocks around this idea thatif Donald Trump's team at theWhite House is able to get through easing of theregulations in the banking industry, that that is going to cause profits to go way up.

It's hard to see right now how profits at these banks that are earningmore money than they've ever end before. Even Bank of America -- which has dug itself out of the financial crisis but is still deepin the throes of seeing its profitability recover -- even it has shot way up. So the question is,what does that mean for investors? Andwhat it means to me is thatyou have to be really careful in this zone right now,because I don't think we can expect a 25% boost in profit at these big banks that areearning so much money. And JPMorgan Chase is earning more than it's ever earned on a quarterly basis. It's just hard to understand how, even if there are significant deregulatory moves made in this area, that it's going to have such a huge impact on profits.

Lapera: Yeah. So basically, thestock-price increase is a gamble byinvestors thinking that these banks will make way more money than they'realready making. And as you pointed out,Maxfield, the banks are already makingquite a bit of money. So I'm not 100% sure howthey would make even more money just like that as soon as deregulation happens. Theother thing to think about is, I think there's a post-election high where everyone was like, "Yeah,he's going to get in there, the first 100 days he's going to get a lot pushed through," and the reality is, inWashington D.C., nothing happens quickly. Andthat's for a reason; that's a protective thing that D.C. has. I knowpeople hate to hear that,but it's good that people can't make rash decisions andchanges to legislation,whether or not they're good. This way,it gives everyone a lot of time to considerwhat the ramifications of any givenlegislation will be. But that also means thatlegislation takes a really long time to push through. Andbanking regulation, as dry and complex as it is,is probably going to take even longer than other types of regulation.

Maxfield: And we saw, with the challenges,trying to get that initial healthcare bill through, that just because there'sunity between the branches,Republican-controlled White House, House, and Senate,there are still factions in there that aregoing to make the legislative agenda difficult to get through. Here is where it gets really dicey for investors. Because bank stocks are up on an expectations-infused rally, it means that investors arethinking and making decisions in the political context. One of the things we know, when a person makesdecisions in the political context, is that it isextremely difficult,regardless of which side of the aisle you're on, to make objective, fact-based decisions. In fact, there's this great book, Mistakes Were Made (but Not by Me), that digsinto a particular type ofbehavioral biasknown as cognitive dissonance. One of the things that they talk about in that book is, there was a study done where people,Democrats and Republicans, were put into MRIs,and then confronted with information that was eitherconsistent or inconsistent with their political beliefs. And what they saw was, when information that was consistent with your political belief was introduced and you started thinking about it, the area of your brain that isresponsible for making deep,analytical insights started firing. But what happened was, ifinformation that you disagreed with politically was introduced, that same area of the brain, they saw, actually shut down. So, what that means is, the way our brain works, when there isinformation in the political context that we agree with, we incorporate that into our analysis,but the information that we disagree with, we do notincorporate that into our analysis. And in the investing world, which is really unforgivingbecause you're talking about numbers and money,you need both sides of the story to have a balanced approach.

Lapera: Yeah. AndI think I actually see where you're going with this. There was a story out ofWisconsin.I will quote to you part of it. "WhenGOP voters in Wisconsin were askedlast October whether the economy had gottenbetter or worse over the past year, they said worse, by a margin of 28 points. Butwhen they were asked the very same question last month," in March, "they said better, by a margin of 54 points." That's a net swing of 82% between lateOctober 2016 and mid-March 2017. That's crazy,becausethere's no way the economy has changedthat much between October and March. So it really justcomes down to people'sperceptions ofhow the economy is doing. Andeven more than that, when you askDemocrats that same question,it was basically flipped. Democrats were saying, "We think the economy is way worse; we think a recession is imminent." So this issomething that I don't know it's ever been seen before, but we're really letting political activity cloudhow we're viewing the economy, whichfundamentally can alter how you view investing decisions.

Maxfield: Right,and the Michigan consumer-confidence survey, which is an even broadersurvey than the Wisconsin survey, itconfirmed the same thing. It found astark partisan dividebetween how Democratsview the economy and how Republicans view the economy. In fact,I can't remember if it was January or February when it was the largest partisan divide that survey had ever seen,but I think it narrowed a bit in a more recent month, but it's still relatively wide. To your point, what they have seen is, sinceDonald Trump has taken office,optimism amongRepublicans has shot way, way up, but among Democratsit has shot way down. So Democrats are expecting, generally, an imminentrecession. The data shows they'reexpecting a recession. TheRepublicans are expecting a robust recovery. This just goes to the point. I think there's two points here. First, consumer-confidence data is more complicated than the headline number. Second, this goes to the point that when you're in the political realm,even when you're making decisions about things that are non-political, i.e., the economy or investing, politics still creeps in and short-circuits a rational,objective, fact basedthought process.

Lapera: Yeah. I mean,honestly, the truth is probably somewhere in between,because that's generally how it goes with these things. ButI think the message we're trying to deliver to you, dear listeners, is that you should do your best to make decisions about companies based on the company'sfundamentals. Ignore the outside noise. Don't let it creep in. Focus on what you think is good for a company. Don't make bets on what you think other people are going to do. That's how you evaluate a company. That's howyou become a long-term thinker and a long-term investor.

Maxfield: Andeven more generally, Gaby, we knowhow difficult it is to makeaccurate forecasts. So when you're investing, being a really good investorisn't necessarily being the one who's able to forecast into the future the mostaccurately, although that would certainly help.[laughs] It would help,but it's almost pointless to try,because it's a crap shoot, almost,trying to forecast into the future. So, what you see with really good investors, andI think this is what you're saying, is they focus on two things. Lookat the quality of the company itself, and whether it hascompetitive advantages, whether its profitability is on the rise, whether it's run in an efficient manner, and try and look at and compare that to where the valuations are at any given time. And then, focus your analysis around those things, and do your very best to cut out any extraneous noise that couldpotentially mess up your results.

Lapera: Yes,I 100% agree with you. On that note,I think we're actually done. I think we've run a little bit over. I think we might be boringAustin a little bit. Sorry, Austin!

Asusual, people on the program may have interests in the stocks they talk about, andThe Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at, or by tweeting us @MFIndustryFocus. If you want,I can send you those two news articles. Theymight be behind paywalls; I don't know. I have a ridiculous number of newspaper subscriptions,so I remain uncertain. ButI'm more than happy to send you the links about those consumer-index articles. Thank you toJohn Maxfield for joining us,with your excellent knowledge, as usual. And thanks to Austin Morgan,today's wonderful producer. Andthank you to you all for joining us. Everyone, have a great week!

Gaby Lapera owns shares of JPMorgan Chase. John Maxfield owns shares of Bank of America and Wells Fargo. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.