Banks’ Earnings Pop Masks Deeper Concerns

Major U.S. banks have turned in big profit gains this season, but the news isn’t all good.

Much of the earnings increase is coming from cutting costs, rather than growing their core lending businesses. A boom in mortgage refinancing looks like it’s about to peter out. And regulators are considering stricter new rules that would force the banks to shore up their cash.

“It was a very good quarter, with headline numbers better than expected,” said Anthony Polini, an analyst at Raymond James. But, he added, “the jury is still out” on the second half of the year. And he, for one, isn’t overly optimistic: Polini thinks that revenue from mortgages and trading activities, which helped earnings this time around, will suffer through the end of the year, and questions whether the U.S. economy can grow enough to support anything more than sluggish loan demand.

Bank of America reported second-quarter earnings Wednesday, following JPMorgan Chase and Wells Fargo last week and Citigroup on Monday.

Here’s more on what to take away from the season:

THE HEADLINE NUMBERS: There’s no denying that profits popped compared with a year ago. At Wells Fargo, whose profits grew by the smallest amount, earnings rose 20 percent. At Bank of America, they leaped 70 percent.

The problem is that it wasn’t revenue growth that was driving the earnings. Revenue was basically flat at Wells Fargo, up 3 percent at Bank of America, 8 percent at Citi (where earnings rose 26 percent) and 14 percent at JPMorgan (where earnings rose 32 percent).

WHERE EARNINGS CAME FROM (AND DIDN’T COME FROM): There were several big factors driving second-quarter earnings growth.

The banks were able to set aside less money for potential bad loans, because consumers are defaulting on loans less often and because banks have gotten stricter about who they make loans to – though that’s a double-edged sword, because making fewer loans also means lower revenue.

Banks have also benefited from a recent increase in interest rates, which means they can charge higher interest on their loans.

Investment banking units also did well. Though there was uncertainty through part of May and June about how long the Federal Reserve will continue its support for the U.S. economy – causing turbulence in stock and bond markets – banks were still able to enjoy higher revenue from trading for their clients and book gains on their own stock investments. Besides, volatile markets aren’t all bad: Many bank clients see it as a prime time to trade, or will want help recalibrating their investment strategies.

On the other hand, results from consumer banking have tended to be sluggish, a troubling sign in an economy built mostly on consumer spending.

“At JPMorgan Chase and Citigroup, the consumer was very, very weak,” said Erik Oja, the U.S. bank stocks analyst at S&P Capital IQ. “And that’s just because of retrenchment. People are paying down credit card balances and being more cautious.”

Loan growth across the banking industry is down so far this year, and the industry’s loan-to-deposit ratio is at its lowest since 1984, added CLSA analyst Mike Mayo.

“This is not the stuff that robust recoveries are made of,” Mayo said.

PENNY PINCHING: Banks were also able to earn more money because they slashed costs.

Notably, Bank of America cut about 18,300 jobs over the year, or nearly 7 percent of its workforce. It also got rid of about 5 percent of its branches, and promised to cut more.

JPMorgan and Citigroup also cut jobs, and reeled in spending on equipment, offices, advertising and marketing. Some analysts questioned how long cost-cutting can continue to prop up earnings; there’s only so much a company can cut before it becomes counterproductive.

Chris Whalen, managing director at Carrington Investment Services, said that most of the banks’ earnings growth this season came from cutting costs and releasing some of the money they had previously set aside for bad loans.

“There wasn’t a lot of strong revenue growth,” Whalen said. “It’s the same story we’ve had for the past few quarters.”

THE REFINANCING BOOM: Mortgages have helped drive results at the banks for the past year, but it’s not clear how much longer that will last. Most of the boom has come from people refinancing their mortgages, rather than buying new homes, and that is likely to peter out as interest rates rise.

In a call with analysts, JPMorgan’s chief financial officer, Marianne Lake, said that if rates stay at or above their current levels, the mortgage refinancing market could be slashed by 30 to 40 percent – more than analysts were expecting.

“Hopefully, we’re wrong,” Lake said. “And hopefully, it will be better than that.”

Mortgage applications at JPMorgan and Wells Fargo were both down compared with a year ago, including a 30 percent drop at Wells. Bank of America’s leaders noted that their pipeline of mortgage applications had fallen 5 percent over the quarter.

Whalen said that the main takeaway from this season’s earnings is that mortgage volumes “are going to fall even faster than we thought,” he said. “So all the analysts that have been out there banging the table, bullish on this, have to reassess.”

THE REGULATORY OVERHANG: Another hot topic during bank earnings was the so-called leverage ratio.

Last week, U.S. regulators proposed rules that would require big U.S. banks to hold greater levels of capital. The regulators say that having more cash on hand will protect banks in troubled times.

While the new rules wouldn’t take effect until 2018, and the banks said they are already at or near many of the proposed capital levels, the debate was another reminder of the government’s stricter control over the industry. The banks say the new rules could constrain them from lending and put them at a disadvantage to international competitors.

Bank of America chief financial officer Bruce Thompson said in a call with analysts that there is concern that “some of the policies out there (could) possibly have an impact on the availability of undrawn credit.” If banks are required to hold higher rates of capital, he said, then “by definition,” the cost of that credit “will need to migrate up.”