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Outsized credit costs and trading revenue among the big banks

| July 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.

A recap of the highlights and lowlights of the first week of US bank earnings, and how it impacts relative value of the bonds among the big domestic banks.

JP Morgan (JPM: A2/A-/AA-) once again proved it pays to be the top global banking franchise among US banks, as record trading revenue helped offset a second consecutive quarter of elevated credit provisioning. Shares are up moderately as stocks take a turn higher in mid-morning trading. JPM reported 2Q20 EPS of $1.38, down -51% year-over-year, but well through analysts’ consensus estimate of $1.01. JPM’s dividend will remain unchanged ($2.8 billion, $0.90 per share), while repurchase remain under Fed mandated hold through at least 3Q20. The bank booked a $10.5 billion credit provision for the quarter, which included a higher than expected reserve build of $8.9 billion. Those efforts follow the $8.3 billion provision for credit costs in the prior quarter, which included a $6.8 billion reserve build. Just under half of this quarter’s reserve build was ascribed to the Card segment, reflecting the still weakening US consumer. Once again, JPM cited the Oil & Gas, Real Estate, Lodging and Retail industries as sources of stress in the second quarter. Revenue was up +14% year-over-year to $33.8 billion on the outstanding trading performance. Fixed Income trading alone was up +99% YoY to $7.34 billion, shattering expectations; while Equity trading revenue jumped +38% year-over-year to $2.38 billion. The combined +79% increase in trading revenue represented a record performance for the second consecutive quarter. Investment Banking rose +91% year-over-year, driven by the extraordinary environment for both Equity and Debt Underwriting. Overall results included a mark-up in held-for-sale securities; actual IB fees were up +54%. Loans were up a modest +4% firmwide, versus a massive +25% build in deposits, fueled in large part by the PPP.

Bottom-line: 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’s “fortress balance sheet” and extraordinary capital position, as well as its record shattering performance in the challenging operating environment, dictate its leading stature among US money center banks.

Exhibit 1. Maintain a preference for 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, Bloomberg/TRACE G-spread Indications

As anticipated, Wells Fargo (WFC: A2/A-/A+) generated negative headlines with another sizable provision for credit costs – although the stock took a hit as the $9.5 billion recorded in 2Q20 was substantially larger than the ~$5.5 billion that analysts were anticipating and more than double the $4.0 billion (and $3.1 billion reserve build) booked in the prior quarter. We were not particularly surprised with the magnitude of losses at WFC, as it serves the bank’s interests to build out reserves as much as possible in what was clearly set to be a disastrous second quarter. WFC does not have the benefit of outsized trading revenue to help offset the impacts to traditional banking lines. Net charge-offs were just $1.1 billion, leaving $8.4 billion to bolster reserves as nonaccruals jumped +28%. The result was a net loss of $2.4 bn or ($0.66) EPS down from the impressive $6.2 billion profit the bank booked a year ago. As dictated by the Fed in the recent Stress Test announcement, where trailing earnings dictate dividend allowance, WFC reduced its dividend to $0.10 per share from $0.51, and share repurchases remain on hold with the rest of the peer group.  Top-line performance declined -21% year-over-year with total revenue of just $17.8 billion in 2Q20. Loans declined -7% sequentially, while deposits increased only +2% — far less than what we saw at JPM and are likely to see industry wide. The bank remains under a mandated asset cap according to a consent order from the Federal Reserve. WFC’s $1.2 billion operating losses included $765 million in customer remediation accruals as well, offsetting several one-time gains. Management stressed the efforts the bank is making during the pandemic to assist customers, defer payments and fees, and fund commercial loans associated with the PPP.

Bottom-line: The market was anticipating a disastrous 2Q20 for WFC without the benefit of trading revenues to offset the inevitable reserve build for bad loans, and the bank largely delivered. We were not overly surprised by the size of the charges, given that WFC did not appear to do enough in the prior quarter. Meanwhile, WFC is still working toward repairing its severely bruised reputation, and is struggling to make headway amidst the difficult operating environment. 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. 

Citigroup (C: A3/BBB+/A) shares initially traded up but sold off as equity investors contemplated the longer-term implications of the massive provisioning in 2Q20. The bank reported 2Q20 net income of of $1.3 billion or EPS of $0.50, down -74% year-over-year, roughly in-line with analysts’ consensus estimate. The bank booked $7.9 billion in provisions in the quarter, $5.6 billion of which went to boosting reserves for future losses. The total provision was up from $7.0 billion in credit costs for the prior quarter when Citi adopted new CECL accounting standards and built out reserves by $4.9 billion. The bank noted that Card spending declined nearly -25% in the quarter, while balances were down roughly -7% year-over-year. Total revenue increased 5% year-over-year to $19.8 billion. Top-line performance was driven by a +68% year-over-year gain in Fixed Income trading revenue to $5.6 billion, while Equity trading revenue actually declined by -3% to $770 million. Investment Banking fees jumped +37% year-over-year as Debt Underwriting fees rose substantially, following the Fed’s announcement various credit facilities to bolster the debt capital markets. The bank will keep its dividend unchanged, while the ability to execute share repurchases remains on hold through 3Q20.

Bottom-line: Once again, 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.

By all accounts, it appears that Goldman Sachs (GS: A3/BBB+/A) knocked it out of the park in 2Q20. In addition to record paced trading and Investment Banking revenue, GS booked a $1.38 billion gain on securities holdings, completely offsetting the $900 million loss booked in the prior quarter when GS got caught wrong-footed when the market turned. Total trading revenue jumped +93% year-over-year, led by a +149% gain in Fixed Income (FICC) revenue to $4.24 billion – the best performance in nine years. Equity trading revenue jumped +34% to $2.94 billion. Solid execution across most business platforms was evident in FICC, as management highlighted performance in Rates, Commodities, and Mortgage businesses, only citing loan trading volumes as a source of weakness in the quarter. In Investment Banking, market activity was up, but also GS appeared to pick up considerable market share versus peers on the league tables, booking a +122% gain in Equity Underwriting to $1.06 billion, and a +93% year-over-year increase in Debt Underwriting to $990 million. The strong performance helped offset a -11% decrease in M&A Advisory, though activity remained decent despite the drop-off in transaction closings year-over-year.

Bottom-line: Goldman has been subject to quarter-to-quarter fluctuations in performance recently, but you can clearly mark this one as a win and a classic Goldman beat on expectations. We have maintained our view that those fluctuations remain mainly an equity story than an actual credit concern, but it has built some disparity with the more consistent results coming out of peer Morgan Stanley over the past few years. The first two quarters of 2020 have been squarely focused on GS’ trading prowess, with limited attention on any of the lingering overhang of the 1MDB scandal and any residual fallout with global regulators.

Exhibit 2. With two consecutive strong performances and still wider spreads overall, the additional spread pick-up available in GS over MS appears increasingly attractive

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

On the third day of US money center bank earnings for 2Q20, results echoed much of the sentiments that have been reported so far by peers – extraordinary trading and Investment Banking revenues helped offset the outsized credit provisioning taken in the second quarter. In the case of Morgan Stanley (MS: A3/BBB+/A), the brokerage may have been edged out in what has increasingly become a rare win for their counterpart Goldman Sachs (GS); but only by a relatively thin margin, as MS’ efforts resulted in record profits for the quarter. MS’ 2Q20 top-line revenue jumped 31% year-over-year to $13.4 billion, resulting in $3.2 billion in net income of $1.96 EPS per diluted share, or adj. EPS of $2.04 well ahead of the $1.23 consensus estimate. Fixed Income (FICC) trading revenue was up +168% year-over-year to $3.0 billion, outweighing the more modest +23% gain Equity trading revenue year-over-year to $2.6 billion, for a combined +68% gain in Trading top-line results. Management highlighted the pick-up in securitized products, credit and commodities as sources of heightened trading activity. Investment Banking revenue was up +39% year-over-year, as a +68% gain in Debt Underwriting (to $707 million) and +62% gain in Equity Underwriting ($882 million) off set the -9% drop off in M&A Advisory ($462 million). MS maintains their edge in their retail platforms, as the broker-dealer saw record inflows to their Investment Management business, fueling revenue growth of +6%. MS provided a brief update on the E*Trade acquisition, which it expects to close in 4Q20.

Bottom-line: MS shares are still trading up ~3-4% despite the broader sell-off in stocks late morning, but for a second consecutive quarter closest peer GS’ trading results had already stolen a bit of the thunder among the two names. 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 purchase of E*Trade to potentially further its edge across these platforms. Both names remain core holdings for the US Banking segment–which we currently view as an Overweight—but we increasingly prefer the spread pick available in GS over MS in the intermediate part of the curve despite the lingering presence of global regulatory risks.

Exhibit 3. Continue to prefer Citigroup intermediate paper over Bank of America

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

Bank of America (BAC: A2/A-/A+) left investors wondering if they had taken enough provisions in 2Q20, as total credit costs and reserving efforts came in well below peers. BAC booked a $5.1 billion provision for the quarter and built out reserves by $4.0 billion; which followed the $4.8 provision for credit losses last quarter with a $3.6 billion reserve build. Those efforts compared with $7.9 billion for 2Q20 at closest peer Citigroup, and over $10 billion by JP Morgan Chase. Shares of BAC are down modestly following the announcement. The bank recorded net income of $3.5 billion, or EPS of $0.37, ahead of the $0.25 consensus estimate.  Total trading revenue rose +35% year-over-year (ex-DVA), ahead of expectations, with Fixed income trading revenue up +50% to $2.57 billion and Equity trading revenue up just +7% year-over-year to $1.23 billion, just shy of expectations. Investment Banking fees were +57% year-over-year to $2.16 billion. Loans were up +8% versus +15% deposit growth in the quarter, net interest income was under pressure, declining -11% in 2Q20.

Bottom-line: BAC’s balance sheet and capitalization remain well-positioned to weather the near-term economic downturn and further deterioration in credit, should management’s efforts to build out reserves prove insufficient relative to peers. We believe investors in BAC credit remain well-compensated for the risks, given the relative stability of the sector; however our preference between the two names remains with Citigroup on relative valuation and available spread pick in the intermediate part of the curve.

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