The Long and Short

Bank earnings show strength beyond the loan book

| October 15, 2021

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 6 US money center banks put up some big numbers thanks in large part to investment banking—specifically record M&A advisory revenue—equities trading and continued, albeit smaller, reserve releases. For another quarter this is all helping offset the ongoing weakness across traditional lending categories. There are some nascent signs of loan growth and recovery, but it largely appears to be in the very early stages. Auto lending remains hampered by supply chain issues and credit card lending has been hamstrung by pandemic related stimulus.

A re-cap of each bank’s performance for 3Q21 and updated trading recommendations for how bond investors should allocate big 6 bank holdings in the near-term. Our sector weighting view on the broad banking sector remains marketweight, although we prefer the big banks to their regional counterparts.

Exhibit 1. Global M&A volume saw its biggest quarter in 3Q21 since 2015

US Bank Earnings 3Q21 Recap

JPMorgan Chase’s (JPM: A2/A-/AA-) 3Q21 earnings results were largely an echo of the previous quarter, as extraordinary investment banking revenue and a sizable (albeit progressively smaller) reserve release helped enable the bank to deliver a large beat on earnings expectations. Where the third quarter appeared to differ from the prior period was in traditional loan growth, which finally began to demonstrate a modest recovery for the first time since the start of the pandemic. JPM shares initially reacted favorably but appear to be trending downward at the conclusion of the earnings call and the market open. JPM bond spreads appear unchanged by the 3Q21 earnings results, as there has been limited activity in the Big 6 banks ahead of the anticipated issuance that typically coincides with reporting season. JPM reported EPS of $3.74 well ahead of the consensus estimate of $2.97. Total managed revenue increased 2% to $30.4 billion, also ahead of expectations. The bank released $2.1 billion in reserves against $524 million in net charge-offs for a net benefit of $1.5 billion to earnings or $0.52 EPS. Other one-time items included a $566 million tax benefit that boosted EPS by $0.19. The latest release leaves total reserves for credit losses at $20.5 billion down from a pandemic peak of $34.3 billion.

The earnings performance was driven by the 52% jump in IB fees led by record breaking M&A advisory activity and solid IPO volume. IB revenue was $3.0 billion for the quarter. Total trading revenue of $7.4 billion remained elevated but was down 5% Year-over-year versus the record top-line performance in 3Q20, as Fixed Income revenue of $3.7 billion was down 20% Year-over-year. JPM attributed the decline to commodities, rates, and spread product, all of which were firing on all cylinders in the prior year period. Equity trading revenue helped offset the decline and was up 30% Year-over-year.

On the lending front, firmwide average loans increased 5% year-over-year versus 19% growth in deposits – an impressive feat given the negative impacts of the delta variant during the quarter, and ongoing supply chain disruptions impacting auto sales. CEO Jamie Dimon highlighted growth in card spending, home loan originations—which were up an impressive 43% in the third quarter—and perhaps most notably, a nascent recovery in commercial real estate. Asset & Wealth Management saw 21% growth in revenue year-over-year as Assets Under Management (AUM) increased 17% to $3.0 trillion on higher market levels and net inflows.

Bottom-line: Our sector weighting view on Domestic Banks remains Marketweight since late 2020, reflecting tighter valuation in spreads and still present headwinds in the industry, such as persistently low rates, constrained loan demand, and the relatively flat yield curve. 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.

Exhibit 2. We maintain our 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

Bank of America (BAC: A2/A-/AA-) appears to have delivered a quarter of get-right results in 3Q21 after disappointing investors in the previous quarter. Initial reaction in equities appears to be favorable, while BAC bond spreads remain largely unchanged. Third-quarter net income was $0.85 versus the $0.71 consensus estimate, a 58% increase year-over-year, while top-line revenue increased 12% to $22.8 billion, also ahead of expectations. BAC took a $1.1 billion reserve release, which provided a benefit of $624 million to earnings after net charge-offs of $463 million. The bank released reserves of $2.2 billion and $2.7 billion in the prior two quarters, respectively. Allowance for loan losses now stands at about $13.2 billion down from $14 billion in the prior quarter and appears unlikely to be a major source of earnings surprise going forward as management continues to taper off releases. After investment banking fees failed to live up to rivals’ performances in the prior quarter, BAC saw a 65% increase in 3Q21 to $654 million on record M&A advisory activity. Likewise, the lack of loan demand that disappointed in the previous quarter gave way to a firm-wide 6% sequential increase in average loans and leases (excluding PPP) and annualized grown of 9%. Sales and trading revenue was up 9% year-over-year (ex-DVA) to $3.6 billion as fixed income fell 5% to $2.0 billion, offset by a 33% increase in equities trading to $1.6 billion.

Bottom-line: Third quarter performance was much improved sequentially for BAC. We maintain our view that investors continue to be properly compensated for the risk, particularly given the relative stability of the sector amidst a difficult operating environment. However, our preference between the two names remains with closest peer Citigroup on better risk/reward.

Exhibit 3. We continue to see better risk/reward in Citigroup intermediate paper over Bank of America

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

Citigroup (C: A3/BBB+/A) appears to have reported results that were mostly in-line with the broader peer group, with the uptick in equities trading revenue and investment banking fees enabling the bank to beat expectations. Citi also once again released significant loan loss reserves, helping bolster the bottom line. Citi released $1.16 billion in reserves, providing a moderate boost to net income after accounting for the $961 million in net charge-offs in 3Q21. Other one-time items included a $680 million pre-tax loss related to the sale of the Australian consumer unit. Net income ultimately increased 48% Year-over-year to $4.6 billion well ahead of the consensus estimate, as EPS reached $2.15 – a 58% increase year-over-year given the reduction in shares outstanding. Top-line revenue declined 1% to $17.2 billion including the one-time sale charge and rose 3% excluding it. Total trading revenue declined 4% year-over-year to $5.02 billion, as fixed income dropped 16% to $3.18 billion, offset by a 40% increase in equities trading to $1.23 billion. All trading came ahead of consensus expectations. Total investment banking revenue increased 39% year-over-year to $1.92 billion. M&A advisory more than tripled to $539 million, while equity underwriting increased 5% to $507 million and debt underwriting increased 19% to $877 million. In traditional lending categories, Citi saw card spending up significantly in the third quarter, but total card loan balances were still down 3%, reflecting the improving but still difficult landscape for consumer lending.

Bottom-line: Citi appears to have shaken off the regulatory issues from late 2020, delivering results that have been mostly in-line with peers over the past several quarters, helping smooth the transition for relatively new CEO Jane Fraser. We maintain our view that Citi remains among the preferred risk/reward picks in the Big Bank peer group, within the context of our Marketweight for Domestic Banks within the IG Index.

It was hard not to be impressed with Morgan Stanley’s (MS: A1/BBB+/A) performance in 3Q21, even as peers had already set the tone for a strong quarter of overall results. The substantial gains at its Wealth and Investment Management businesses continued to demonstrate how the recent acquisitions of E*TRADE and Eaton Vance are helping to build out its franchises. MS reported 3Q21 net income increased an impressive 37% to $3.7 billion or EPS of $1.98 (or $2.04 adjusted versus the $1.69 consensus estimate). Net revenue increased 26% Year-over-year to $14.8 billion, also well ahead of expectations. Similar to peers, MS saw elevated levels of investment banking activity to help offset the year-over-year drop in fixed income trading revenue. Total investment banking revenue hit a quarterly record at $2.85 billion, a 67% increase from the prior year period. M&A Advisory led the way nearly tripling year-over-year to $1.27 billion. Equity underwriting increased 16% to $1.01 billion and debt underwriting increased 19% Year-over-year to $567 million. Fixed Income trading revenue was down 16% $1.64 billion from the extraordinary levels in 3Q20 but came in ahead of consensus expectations. That was offset by a 24% year-over-year increase in equities trading to $2.88 billion, which also beat estimates. We would have to wait until peer Goldman Sachs (GS) reports tomorrow to see if MS retained the top spot in the industry for all equities trading activity, which it regained from GS in the prior quarter. MS continues to stand out in wealth management versus the broader peer group, where the impact of the E*TRADE acquisition resulted in a 28% increase in net revenue to $5.94 billion, and Investment Management where the Eaton Vance acquisition resulted in a 38% increase of net revenue to $1.45 billion.

Bottom-line: We maintain our view that MS boasts the preferred longer-term franchise for retail brokerage over GS. The integration of both the E*TRADE and Eaton Vance acquisitions continues to bolster quarterly results. MS and GS both remain core holdings for the US Banking segment–which we currently view as Marketweight. Nevertheless, our trading preference continues to be in favor of the spread pick in GS over MS in the intermediate part of the curve when available.

For the first time in three quarters, Wells Fargo (WFC: A1/BBB+/A+) booked a one-time charge related to the consumer banking scandals of the past, in the form of a relatively small $250 million operating loss associated with the September 2021 Office of the Comptroller of the Currency (OCC) enforcement action related to home lending. Management highlighted the recent expiration of the 2018 CFPB consent order regarding its retail sales practices. The bank continues to move on from its past misdeeds and toward an eventual turnaround, even as it continues to operate under the Fed-imposed asset cap. WFC released $1.7 billion in reserves versus $257 million in net charge-offs for a benefit to earnings of about $1.4 billion or $0.30 per share. EPS for the quarter was $1.17 up from $0.70 in the prior year period and modestly ahead of the $0.97 consensus estimate. Top-line revenue declined 2% Year-over-year to $18.8 billion which was roughly in-line with expectations. Net interest income declined 5% year-over-year due to lower loan balances, as firm-wide average loans were down 8% to $854 billion versus $932 billion in the prior year period. Still, management highlighted that period-end loans increased for the first time since the beginning of the pandemic, a modest sign of progress amidst the challenged lending landscape. On the cost front, WFC continued to demonstrate improvement. While the Efficiency Ratio was up sequentially to 71% from 66% in the prior quarter, it improved markedly from the 79% in the prior year period. The initial response in WFC share price appears favorable while bond spreads remain unchanged.

Bottom-line: WFC is still working toward repairing its severely bruised reputation under new management but continues to make gradual headway. We would be buyers of WFC credit on any short-term or headline-related weakness, but bonds currently do not offer enough discount to JPM to compensate investors for the still present operational and regulatory risks associated with the credit.

Exhibit 4. Spreads have gotten very tight between GS and MS, but we still prefer the spread pick-up in GS where available in the intermediate part of the curve

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

The big 6 US money center banks may have saved the best for last as Goldman Sachs (GS: A2/BBB+/A) shattered expectations and capped off its most successful year by revenue, earnings, and EPS in just the first three quarters of 2021. Net revenue rose 26% to $13.6 billion, well ahead of the consensus estimate of $11.6 billion. EPS of $14.93 rose 66% over the prior year period and shot through the consensus estimate of $9.92 per share on net earnings of $5.38 billion for 3Q21. Unlike its more traditional banking peers, GS did not release reserves and instead took a small $175 million provision for credit costs in 3Q21 after taking just a modest $92 million benefit to earnings in the prior quarter. Similar to peers, GS reported a massive 88% gain in Investment Banking revenue to $3.7 billion, well ahead of estimates. M&A advisory was up a tremendous 225% to $1.65 billion, while debt underwriting increased 27% to $726 million and equity underwriting was up 37% to $1.17 billion. Meanwhile, unlike most of the peer group, GS did not need to offset a year-over-year decline in trading revenue, as global markets revenue saw a 23% year-over-year increase to $5.6 billion. Debt trading revenue was flat year-over-year in 3Q21 at $2.51 billion, while equities trading rose 51% to $3.10 billion—which regained the top spot in the industry over closest peer Morgan Stanley ($2.88 billion). All-in-all, 3Q21 appears to have been yet another consecutive quarter of very impressive results relative to the broader peer group for GS as it continues to execute in its key markets.

Bottom-line: Goldman had been subject to quarter-to-quarter fluctuations in performance in recent years, but in the past year-plus GS has demonstrated tremendous consistency and top-tier execution in volatile markets. The playing field does appear to have been leveled a bit with closest peer Morgan Stanley over the past few quarters, particularly with GS once again regaining its top spot among all equity trading shops on the street. We continue to see good relative value in GS intermediate bonds versus the broader peer group of US money center banks.

Dan Bruzzo, CFA
1 (646) 776-7749

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