Credit costs tempered as trading revenue climbs

| October 16, 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.

JP Morgan announced another solid outperformance, Citigroup’s call became contentious and Goldman Sachs had one of the best trading performances among its peer group. Meanwhile Wells Fargo continues to absorb charges due to its turn-around effort, and Bank of America’s underwhelming trading performance offset a relatively modest provision for credit costs. Highlights and lowlights from the first bank earnings reports of the third quarter of 2020.

JP Morgan (JPM: A2/A-/AA-) reported third quarter 2020 EPS of $2.92, well ahead of the $2.26 consensus estimate, as net income grew +4% year-over-year to $9.4 billion, more than double the amount recorded in the prior quarter. Total managed revenue of $29.9 billion was roughly flat year-over-year. The big headline for the net earnings numbers was JPM’s much smaller than expected $611 million in credit costs for the quarter, which was actually down -60% year-over-year. The provision was exceeded by charge-offs enough to create a $569 million reserve release. The street was expecting closer to $2.4 billion in credit provisions for the quarter, following the nearly $10.5 billion set aside in the prior quarter (and $8.3 billion in the first quarter of 2020). While the line item was clearly favorable to credit and a sign that Covid-19 related risk may be abating, those sentiments were somewhat offset by JPM keeping credit reserves at an elevated level of nearly $34 billion. Management also warned that the worst of consumer related losses likely will not materialize until the second half of 2021. Lower provisions were also echoed by a smaller than expected number at Citi in 3Q20. As most were anticipating, JPM’s top-line performance was driven by tremendous growth in trading revenue, with capital markets demonstrating heightened volatility and high levels of market participation throughout the quarter. Fixed Income trading revenue jumped +29% year-over-year to $4.6 billion and Equities trading revenue grew +32% year-over-year to $2.0 billion. Investment banking revenue increased +12% to $2.1 billion, as +9% Year-over-year growth in IB fees was driven by higher debt and equity underwriting, helping offset lower activity in M&A advisory. Deposits ballooned +28% year-over-year (+5% sequentially) vs a -7% drop in average loans, further pressuring interest income at the US’ largest lender. On the call, JPM addressed questions about managing the environment and expressed concerns about chasing low rates in order to preserve interest income, instead stating that they are more inclined to preserve capital.

Bottom-line: Maintain an overweight on domestic banks as a defensive strategy amidst broader market credit volatility, despite the prospect for continued rate pressure and other industry headwinds. As the nation’s largest lender and 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 continued strong performance in the challenging operating environment, dictate its leading stature among US money center banks. The negative reaction in stocks to earnings reports from JPM and Citi are more specific to questions regarding equity market valuation rather than actual material concerns for credit – JPM spreads were largely unchanged on the earnings report.

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

Citigroup (C: A3/BBB+/A) had a particularly noisy third quarter 2020 earnings call, as investors drilled management about the regulatory lapses that led to the recently imposed consent orders from the Federal Reserve and OCC and a fine of $400 million. Things got particularly contentious with some analysts even questioning why CEO Michael Corbat, who recently agreed to step down, has yet to relinquish control to the incumbent CEO-elect Jane Fraser – who’s absence from the call seem to agitate investors even further. Management was forced to defend that Citi is not “the next WFC,” while still acknowledging that there was likely a long road ahead in reconciling the shortcomings in oversight that led to the bank being recently flagged by regulators. Like JPM, Citi reported less provisions for credit costs than expected at $2.26 billion vs the consensus estimate of $3.94 billion, an +8% increase year-over-year. Total allowance for credit costs now stands at $26.4 billion, following over $10 billion in reserve building over the prior two quarters. As a result of the lower than expected figure for this quarter, third quarter EPS was $1.40 vs street expectations of $0.92. Net income of $3.2 billion was still down -34% from the prior year period, as top-line revenue declined -7% year-over-year to $17.3 billion. Also like JPM, results were buoyed by strong performance in trading and investment banking revenue. Fixed Income trading revenue increased +18% year-over-year to $3.8 billion, while equity trading rose +15% year-over-year $875 million, both well ahead of the consensus street expectations. Investment banking revenue increased +13% year-over-year to $1.4 billion, as a strong showing in both debt and equity underwriting fees helped offset a -41% decline in advisory revenue.

Bottom-line: Citi’s performance was far less impressive when measured alongside JPM today, particularly as the bank was under fire from the investment community. Under the circumstances, it is not altogether surprising that shares are down significantly in response to today’s results and management’s commentary; but again, as with JPM, we do not believe the concerns reflected from the equity markets are of material credit to concern to bondholders. Citi spreads are largely unchanged in today’s trading session. Despite industry headwinds and the recent events that led to Corbat stepping down, we still believe Citi remains among the preferred risk/reward picks in the Big Bank peer group, within the context of a sector Overweight for Domestic Banking in the IG Index.

For the third consecutive quarter, it appears that Goldman Sachs (GS: A3/BBB+/A) delivered one of the best trading performances in the peer group, with the biggest year-over-year gains in revenue so far among the US money center banks. Global markets revenue rose +29% year-over-year to $4.55 billion, which represents a +49% year-to-date gain through the third quarter 2020. Fixed Income (FICC) trading revenue was up +49% year-over-year to $2.50 billion, while equities rose +10% to $2.05 billion. Once again, GS demonstrated solid execution across most business platforms in FICC, with management highlighting performances in commodities, currencies, mortgage-backed securities and agencies throughout the quarter. Investment banking revenues were more grounded with $1.97 billion, just a +7% gain over the prior year period. The +135% gain in equity underwriting to $856 million helped offset the -27% decline in financial advisory, as global M&A trends declined significantly – GS maintained the #1 market share globally in both M&A and equity underwriting. GS booked just a $278 million provision for credit losses, which was slightly lower than the prior year and a -83% drop from the previous quarter. EPS was an impressive $9.68 in 3Q20, up from $4.79 the prior year and well ahead of the $5.52 consensus estimate, as net earnings soared to $3.62 billion. Firmwide assets under supervision rose +16% year-over-year in the quarter, although down modestly on a sequential basis. The recently announced acquisition of Eaton Vance by Morgan Stanley may put additional pressure on peer Goldman Sachs, who was also rumored to be an interested buyer in ETFC (which closed recently). Like MS, Goldman is seen as building out their asset and wealth management platforms, and is largely playing catch-up to MS in bolstering the retail side of their operations.

Bottom-line: Goldman has been subject to quarter-to-quarter fluctuations in performance in recent years, but the last several have demonstrated tremendous execution in volatile markets, which is a traditional hallmark of GS. We have maintained our view that those quarterly fluctuations remain mainly an equity story than an actual credit concern, but it has built some disparity with the more consistent results that had been coming out of peer Morgan Stanley over the past few years (once again MS will have a tough time matching this level of success when they report 3Q20 results tomorrow).

Exhibit 2. With a strong YTD performances and still wider (albeit narrowing) spreads overall, the additional spread pick-up available in GS over MS still appears attractive

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

The big headline around Bank of America’s (BAC: A2/A-/A+) third quarter 2020 earnings report was the underwhelming trading performance relative to peers, but there was a bit of a silver lining to the bank’s overall results. Undoubtedly trading revenue was a disappointment, as total sales and trading revenue in the global markets division was up just +3.6% year-over-year (ex-DVA) versus the double-digit gains posted at JPM, Citi and GS. Fixed income (FICC) trading increased only 2.5% from the prior year quarter to $2.13 billion, and was down -33% sequentially. Equities trading revenue of $1.21 billion was up a more moderate +5.7% from 3Q19, with management noting a pick-up in client activity in Asia. Total investment banking fees were more commensurate with peers, increasing +15% year-over-year to $1.77 billion. The positive note in the earnings report was that BAC only took a provision for credit costs of $1.39 billion, below the nearly $1.9 billion that the street was anticipating, with a net reserve build of just $400 million. BAC had booked a $5.1 billion provision in the prior quarter and built out reserves by $4.0 billion, and had taken a $4.8 provision in the first quarter of 2020 with a $3.6 billion reserve build. Many believed those efforts were insufficient at the time, but the Bank seems comfortable with their current reserve status heading into potentially difficult quarters ahead for consumer banking, and demonstrated it with a modest third quarter provision. EPS for the quarter was $0.51, as net income declined -15.5% year-over-year to $4.9 billion.

Bottom-line: BAC’s balance sheet and capitalization remain well-positioned to weather the near-term economic downturn and further deterioration in credit. Investors in BAC credit remain properly compensated for the risk, particularly given the relative stability of the sector. However, our preference between the two names remains with closest peer Citigroup on relative valuation and available spread pick in the intermediate part of the curve.

Exhibit 3. Maintain preference for Citigroup intermediate paper over Bank of America

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

Wells Fargo’s (WFC: A2/BBB+/A+) third quarter 2020 earnings results were loaded with charges related to the bank’s ongoing turnaround, which took the place of the outsized reserve build booked in the preceding quarters. WFC booked $961 million for customer remediation accruals and $718 million in restructuring charges that are predominantly earmarked for severance related to headcount reduction. Those charges were partially offset by $452 million of noninterest income related to nonmarketable equity securities. The bank previously booked $765 million in customer remediation accruals in the prior quarter as well. The net result for the third quarter was EPS of $0.42 on net income of $2.04 billion – a 56% drop from the prior year period as interest income remains particularly weak. WFC took only $769 million in provisions to cover credit costs, less than half of what the market was anticipating, but EPS still fell several cents short of expectations, as the other charges more than covered the difference. The bank reported $731 million in net charge-offs, leaving only a negligible amount to bolster existing reserves. WFC previously recorded $9.5 billion provisions for credit costs in the second quarter of 2020 (with an $8.4 billion reserve build) and $4.0 billion (with a $3.1 billion reserve build) in the first quarter. WFC was one of the only money center banks to report a decline in deposits, with period-end at $1.4 trillion, down $27.5 billion sequentially. Meanwhile, average loans fell about 4% from the prior quarter. The bank remains under a mandated asset cap according to a consent order from the Federal Reserve.

Bottom-line: The equity market is reacting negatively to the results, with WFC shares down about 5% in a down day for stock trading; however bond spreads seem less affected with intermediate WFC spreads out by about 3-4 bp, in-line with the broader peer group. Once again the bank’s difficulties were magnified relative to peers without the benefit of outsized trading gains to help offset the weakness. 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 on short-term 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.

john.killian@santander.us 1 (646) 776-7714

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