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Banks build credit reserves and revise guidance

| April 17, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The big US banks launched 1Q20 earnings reporting season headlined by huge reserve builds in credit and revised guidance. After digesting the reports, relative value recommendations for the intermediate part of the curve include being overweight JPM paper, as there does not appear enough additional spread available in WFC to compensate for lingering reputational and regulatory risk; and a preference for Citigroup intermediate paper over Bank of America. Wider spreads overall also make the additional spread pick-up available in GS over MS appear increasingly attractive.

US Bank Earnings 1Q20 Recap (Day 1)

JP Morgan (JPM: A2/A-/AA-) reported 1Q20 EPS of just $0.78 down from $2.66 in the prior year quarter, or roughly a -69% YoY drop in net income to just $2.9 billion for the quarter. The company booked an $8.3 billion provision for credit costs, which included a $6.8 billion reserve build, primarily in credit card and wholesale lending. JPM cited the Oil & Gas, Real Estate and Retail industries as sources of stress. The impacts of provisioning were exacerbated for all banks by the adoption of a new FASB accounting standard (CECL) for recognizing expected losses over the life of a loan versus the previous method (ALLL) of recognition for losses incurred. Top-line performance was down -3% YoY to $29.1 billion in managed revenue. Management revised down guidance for FY net interest income $55.5 billion from the prior estimate of $57 billion. In 1Q20, margin compression led to a -9% drop in revenue in Consumer Banking, and will continue to face additional pressure in the current quarter as well. The bank’s balance sheet expanded rapidly as wholesale customers drew down existing credit lines and commercial borrowers accessed liquidity. End-of-period deposits were up +23%, while loans increased +6%. Trading was a bright spot in the quarter, as global volatility fueled a +34% gain in Fixed Income trading revenue and +28% gain in Equity trading revenue. Strength in trading revenue helped offset a -49% decline in Investment Banking fees, as JPM was forced to book a markdown ($820 million) of held-for-sale positions in their bridge book. Otherwise, Debt Underwriting fees were up +15% YoY and Equity Underwriting fees were up +25% YoY, offsetting weakness in M&A Advisory.

Bottom-line: We maintain an Overweight on Domestic Banks as a defensive strategy amidst ongoing credit volatility. As the premiere franchise among US money center banks, JPM remains a core holding within the segment. While JPM is trading tight to peers, the bank was the only name to launch a post-earnings debt deal (as of Thurs 4/16), with a four-part $10 bn deal that pushed spreads +10-15 bp wider across the curve. We view this temporary widening as an opportunity to add exposure to the name.

Wells Fargo (WFC: A2/A-/A+) reported EPS of $0.01, which included a -$0.73 impact from the $4.0 billion provision for credit costs ($3.1 billion reserve build) and $950 million impairment charge on securities holdings. Net charge-offs on loans were $940 million, an increase to 0.38% of WFC’s total loans from 0.30%. Some reserves were released with CECL adoption. Top-line revenue fell -18% to $17.7 billion from $21.6 billion in the prior year quarter, resulting in net income of just $653 million for the quarter. WFC does not have the benefit of outsized trading revenue to help offset the impacts to traditional banking lines. Like JPM, WFC’s balance sheet expanded as end-of-period loans increased +5% and deposits grew +6%; however the bank remains under a mandated asset cap according to a consent order from the Federal Reserve, and remains in compliance. Growth was driven by commercial and industrial loans, as borrowers drew down revolving lines and originated new loan facilities to contend with the challenging operating environment. Net interest margin (NIM) actually expanded by 5 bps during 1Q20 sequentially (down 2.58% from 2.91% YoY), but that was due to favorable hedge accounting and premium amortization; the future impacts to margins will likely be far less forgiving in the current quarter. The overall Efficiency Ratio (all-in costs to revenue %) jumped to 73.6% from 64.4% on provisioning expenses.

Bottom-line: WFC is still working toward repairing its severely bruised reputation, but we have remained buyers of WFC credit any operational or headline related weakness. Bonds currently appear properly priced relative to peers, and we continue to monitor longer-term progress against the difficult operating backdrop. It does seem like WFC may have been light on their reserve build in 1Q20, at least relative to what some of the other banks took ahead of anticipated losses.

Exhibit 1. We prefer JPM intermediate paper, as there does not appear enough additional spread available in WFC to compensate for lingering reputational and regulatory risk

Source: Amherst Pierpont Securities, Bloomberg/TRACE G-spread Indications

US Bank Earnings 1Q20 Recap (Day 2)

Bank of America’s (BAC: A2/A-/A+) shares took a significant hit alongside closest peer Citigroup, when the bank’s reported 1Q20 results on Wednesday (4/15). As expected, BAC took a sizable $4.8 provision for credit losses versus just $1 bn in the prior year period.  The charge included a $3.6 billion reserve build. The bank recorded EPS of $0.40 versus $0.70 in 1Q20, as pretax income declined -48% YoY. End-of-period loan balances grew +7%, while deposits ballooned by +10%, with borrowers seeking to secure liquidity for the challenging operating environment. Fixed income trading revenue grew +13% to $2.7 billion, while Equity trading revenue increased +39% to $1.7 billion amidst the volatile market backdrop to close the quarter. Investment Banking fees were flat sequentially and up modestly over 1Q19. BAC also saw modest gains in its wealth management businesses.

Bottom-line: BAC’s balance sheet and capitalization appear well positioned to weather the near-term downturn and further deterioration in credit. We believe investors appear well compensated for risks, given the relative stability of the sector; although our preference remains for Citigroup on relative valuation.

Citigroup (C: A3/BBB+/A) reported 1Q20 of $2.5 billion or EPS of $1.05, down -47% YoY, as top-line revenue increased +12% YoY to $20.7 billion.  The bank booked $7.0 billion in credit costs for the quarter, up from $2.0 billion in the prior year period, as Citi adopted new CECL accounting standards and built out reserves by $4.9 billion. The bank returned $4.0 billion to shareholders in the quarter – a factor that remains a future buffer to for capital preservation for Citi and the rest of its peers. Top-line performance was driven by a +39% YoY gain in Fixed Income trading revenue to $4.8 billion and a +39% YoY gain in Equity trading revenue to $11.2 billion amidst heightened market volatility throughout the second half of quarter. Investment Banking fees were roughly flat YoY at $1.35 billion for 1Q20.

Bottom-line: Solid trading performance drives top-line results and helps offset reserving for future credit losses. Citi remains among our preferred picks within the context of a sector Overweight for Domestic Banking credits.

 Exhibit 2. We continue to prefer Citigroup intermediate paper over Bank of America

Source: Amherst Pierpont Securities, Bloomberg/TRACE G-spread Indications

 Goldman Sachs (GS: A3/BBB+/A) got caught wrong-footed in its securities holdings, but investors overlooked the loss on its strong trading performance in 1Q20. GS reported EPS of $3.11 (or $1.21 billion), down from $5.71 in the prior year period. Top-line revenue was $8.74 billion, roughly unchanged from 1Q19. GS took a $937 million provision for credit costs, versus just $224 million in the previous year. The company returned $2.4 billion to shareholders including $1.9 billion in share repurchases. The loss on securities holdings was nearly $900 million, but investors were more focused on GS’ trading gains, taking advantage of volatile markets. FICC trading revenue jumped +33% to nearly $3 billion, while Equity trading revenue was about +22% higher YoY to $2.2 billion. Investment Banking fees were up about +6% overall to $2.2 billion, as heightened debt underwriting late in the quarter helped offset weaker M&A advisory activity.

Bottom-line: Goldman has been subject to quarter-to-quarter disappointments recently, but we have maintained our view that those fluctuations remain mainly an equity story than an actual credit concern. 1Q20 appeared to be mainly about GS’ trading prowess, with limited focus on any of the lingering overhang of the 1MDB scandal.

Exhibit 3. With wider spreads overall, the additional spread pick-up available in GS over MS appears increasingly attractive

Source: Amherst Pierpont Securities, Bloomberg/TRACE G-spread Indications

US Bank Earnings 1Q20 Recap (Day 3)

Morgan Stanley (MS: A3/BBB+/A) 1Q20 top-line revenue declined to $9.5 bn from $10.3 billion in the prior year period, as the bank reported EPS of $1.01 versus $1.39 in 1Q19. Comparable to peer GS, FICC trading revenue was up +29% YoY to $2.2 billion, while Equity trading revenue was up +20% YoY. Investment Banking revenue was down -1% YoY, as the boost in Debt Underwriting failed to offset the drop off in M&A Advisory and IPO activity. MS booked a $1.1 billion loss in its investment holdings, which included a $610 million loss on loans held for sale and a $388 million provision for credit losses.

Bottom-line: MS shares traded roughly flat on the results on the last day of US money center bank earnings, as closest peer GS’ trading performance reported the prior day had stolen a bit of the thunder for the group. MS still maintains the preferred longer-term franchise for retail brokerage, and it will be interesting to monitor how the firm intends to integrate its recently announced purchase of E*Trade.

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