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TheStreet Open House

Regional Bank Earnings: What to Expect

Stocks in this article: RFFITBCOFPNCBBTBACCJPM

NEW YORK (TheStreet) -- When bank earnings season kicks off on Tuesday, investors will be "looking back" at a  fourth quarter displaying many of the industry's biggest challenges, but some of the pressure is expected to subside during 2014.

A major theme for industry earnings over the past year has been the decline in mortgage refinance activity as long-term interest rates have risen.  The Mortgage Bankers Association expects total fourth-quarter originations of one-to-four family residential loans in the United States to decline sharply to $293 billion for the fourth quarter from $401 billion the previous quarter and $597 billion a year earlier. 

For many regional banks, analysts' fourth-quarter estimates indicate the mortgage drag will lead to another quarterly earnings decline.

With long-term interest rates expected to continue rising during 2014 in the wake of Federal Reserve's "tapering" of its monthly "QE3" purchases of long-term bonds, the mortgage slowdown is expected to continue, with total originations dropping another 33% this year to $1.174 trillion from an estimated $1.755 trillion in 2013.

The MBA expects a slight rebound in mortgage activity during 2015, but that's a pretty far way off for banks seeing such a major business disruption, so it's a safe bet that big banks will continue cutting mortgage staff.  Banks will also see expenses continuing to decline as their inventories of repossessed homes continue to decline and more nonperforming loans are resolved.

Interest Rates

Another focus for investors over the next year will be banks' net interests margins.  The margin is the spread between the average yield on loans and investments and the average cost for deposits and borrowings.  The Federal Deposit Insurance Corp. reported that for the aggregate net interest margin for the entire U.S. banking industry was 3.26%, unchanged from the second quarter but down from 3.43% a year earlier.

Up until the third quarter, banks saw their margins narrowing for several years, mainly because the Fed has kept the short-term federal funds rate in a range of zero to 0.25% since late 2008.  The banks saw most of the benefit of the lower cost for deposits several years back, while major portions of their investments and loans continued to reprice at lower rates.  A more normal interest rate curve, with the market yield on 10-Year U.S. Treasury bonds close to 3.00%, is helping.  But banks quickly sell most of the fixed-rate loans they originate to Fannie Mae and Freddie Mac, meaning they book very little interest from the higher-rate loans.  This is a good thing, because even though the long-term rates have risen, they are still very low on a historical basis, and no bank wants to be "stuck" holding a 4.00% mortgage loans, when years later it could be paying a higher rate on savings deposits.

What the banks want to see is a parallel rise in interest rates, which can only come about when the Fed raises the federal funds rate.  The Federal Open Market Committee has repeatedly said that barring a rise in inflation, it is unlikely to raise the federal funds rate until the U.S. unemployment rate falls below 6.5%.

We're getting close to that level, since unemployment rate in December declined to 6.7% in December from 7.0% during November.  However -- there seems always to be a "however" in any discussion of economics -- the improved unemployment rate was driven in large part by 0.2% decline in the labor participation rate to 62.8%.  The labor participation rate declined 0.8% during 2013 -- a large number of people have effectively been driven from the labor force.

So investors will be fixated on the unemployment rate and the federal funds rate this year, just as the market and the media focused on the Fed's tapering plans last year.

C&I

For many of the large regional banks, investors will be expecting a continuing theme of strong growth in commercial and industrial loans.  These loans are not secured by real estate.  Strong C&I growth has been the only real bright spot for may regionals over the past two years, with commercial real estate lending also showing recent gains.  Based on the Federal Reserve's lending estimates, KBW analyst Brian Klock in a note to clients on Jan. 5 wrote that C&I lending volume increased at an annual pace of 14.3% during the fourth quarter from 4.2% during the third quarter.  Quite a bit of the C&I lending activity is loan renewals, which may not mean an increase in loan balances, however, the renewals are wonderful things, since the loans are likely to reprice higher, and include renewal fees.

Regulator Drag and Valuation

JPMorgan Chase (JPM) entered into $17.5 billion in residential mortgage-backed securities settlements during the fourth quarter with various government authorities, and the company's $2.6 billion settlement with the Department of Justice and bank regulators over its role in the Bernard Madoff Ponzi scheme will also be included in its fourth-quarter financial reports.  The RMBS settlements had already been reserved for, but the bank last week said the Madoff settlement would lower fourth-quarter after-tax earnings by about $850 million.

JPMorgan faces more regulatory risk, with ongoing investigations of global banks' LIBOR manipulation by U.S. regulators and multiple investigations at home and abroad of alleged manipulation of foreign exchange trading.

Regulatory angst is reflected in JPMorgan's stock, which trades for just 9.2 times the consensus 2015 earnings estimate of $6.34 a share, among analysts polled by Thomson Reuters, based on Friday's closing price of $58.49.  That's the lowest forward price-to-earnings ratio for any large-cap U.S. bank.

Citigroup (C) is also cheaply valued on a forward P/E basis, with shares closing at $54.72 Friday and trading for 9.3 times the consensus 2015 EPS estimate of $5.91.  At issue is how patient investors may need to be before Citi begins to deploy a major portion of its excess capital through dividends and share buybacks.  Nomura analyst Steven Chubak is quite positive about the prospects for Citigroup's stock over the next 12 months, while Jefferies analyst Ken Usdin rates Citi a "hold."

The third-cheapest large-cap U.S. bank stocks on a forward P/E basis is Bank of America (BAC), with shares closing at $16.77 Friday and trading for 10.5 times the consensus 2015 EPS estimate of $1.59.  That's quite a leap from the consensus EPS estimate of $1.31 for 2014.  In fact, it's the largest jump to the consensus 2015 EPS estimates from the consensus 2014 estimate for any large-cap U.S. bank.

The large regional banks trade higher than the nation's three largest banks.  The following are brief earnings previews for the five big regional names trading at lowest forward P/E ratios, in descending order:

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