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What To Look For In Bank Earnings: All Eyes On Loan Losses

Unlike prior quarters, nobody will care about bank FICC revenues or Net Interest Income.
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Courtesy of ZeroHedge

Tomorrow JPMorgan and Wells Fargo will usher in a historic earnings cycle, one which will see S&P500 earnings plunge the most since the (first) financial crisis…

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… which in turn is a walk in the park compared to the -30% EPS crash expected in Q2…

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… and unlike prior quarters, nobody will care about bank FICC revenues or Net Interest Income. Instead investors will care about only one thing: how much money will U.S. banks lose on loans because of the coronavirus recession.

JPMorgan will kick it off tomorrow morning ahead of the bell, and investors will closely watch comments from CEO Jamie Dimon, especially after his recent ominous investor letter in which he warned that what is coming will "at a minimum include a bad recession combined with some kind of financial stress similar to the global financial crisis of 2008", in his first earnings call since suffering a heart attack. Wells Fargo reports right after and then Bank of America, Goldman Sachs and Citigroup all follow on Wednesday.

And, as noted above, instead of the income statement – where any Q1 gains are expected to be a wash compared to the massive damage suffered across bank balance sheets – investors will seek answers on just how bad the recession will be, include provisions and net charge-offs, the effects of accounting rule shifts known as CECL, or Current Expected Credit Loss, and banks’ capital return plans, particularly regarding dividends as well as when stock buybacks may return.

To be sure, Wall Street estimates have changed dramatically from a month ago, when analysts called for big bank earnings per share to rise in the first quarter from a year earlier by an average of 2%. Now they see declines ranging from 14% to 42%.

That, as Reuters notes, is not just because the impact of the global pandemic is changing and hard to quantify, but also because of a new accounting standard that requires banks to estimate losses for the lifetime of loans and set aside money now to cover them. Those estimates have to be justified to regulators and auditors, and be credible to investors. But they ultimately rely on judgment: a pessimistic management team could decide to take much bigger provisions than optimistic peers at a rival bank, even if they have similar loan books.

To show the difficulty in guessing how that might play out, UBS analysts created a table showing two outcomes for earnings per share: one with usual loss reserves, and another that was about one-third lower, based on their assumptions about the new rule.

"And, the truth is we’re probably going to be very wrong,” lead analyst Saul Martinez said in an interview. “The risk is that it is higher."

“The first quarter is the history, the second quarter the mystery,” said Bloomberg Intelligence analyst Alison Williams.

Investors may prioritize setting “some kind of level for provisions versus stress-tested losses,” while assessing how much customers have drawn down commercial and industrial loans, and how much of soaring delinquencies may turn into realized losses, she said. Capital markets may be strong, Williams added, but “much of that is fueled by trends through mid-February.” Dimon’s remarks will be important even as his recent annual letter offered a “bit of a preview,” Williams said.

Last week, Goldman analysts cut their estimates for big banks for all of 2020 by 40% this week, all due to additional loan-loss provisions. Other issues affecting earnings essentially cancel each other out, they said.

While the uncertainty about bank results also reflects uncertainty about the coronavirus, the new accounting standard add another layer of mystery for banks. Although they have more insight about the financial stress of their borrowers, and therefore more insight about the economy, they do not have a crystal ball about the coronavirus.

This puts bank executives in a pedestal reserved traditionally for central bankers: they will have to be mindful that they could send shockwaves through markets if investors believe they are predicting a protracted and horrid recession, or alternatively, are being blaze and not taking the risks seriously enough.

“It is going to be a tricky balancing act,” said Martinez.

Analysts will also be eager to ask bank executives about assumptions they used for the new accounting standard, known as CECL, for Current Expected Credit Losses, and pronounced like the name Cecil. It has been in the works for a decade but only recently started being implemented.

Across the board, investors will probably “look through first-quarter earnings and focus on credit quality, the second true-up of the CECL loan loss reserves and net interest margin compression,” RBC analyst Gerard Cassidy said via email. Bank stocks have “certainly discounted the expected decline in earnings in 2020,” Cassidy said. Now, investors want to be reassured that "this downturn for the banks will only be an earnings issue and not a balance sheet issue similar to the 2008-2009 financial crisis."

Addressing the CECL issue, Morgan Stanley analyst Betsy Graseck writes that she is baking in a 6-31% increase in reserves from "day 2" CECL estimates in 1Q20. As a reminder, CECL (Current Expected Credit Loss) is the new accounting standard for loan loss reserves which requires life of loan reserving estimates. CECL kicked off January 1, 2020, and will require management teams to estimate life of loan losses for their loan books as of March 31.

While Day 1 CECL estimates are known, the biggest question from investors going into the 1Q20 print likely is: how big will Day 2 reserve build be? Given the uncertainty of the virus trajectory and length of “stay-at-home” directives, street estimates for day 2 CECL charges are very wide.

Morgan Stanley bases its CECL Day 2 estimates on a 10% probability of the most severe stress test that the banks have ever done, the 2018 stress test. This drives a 6-31% increase in reserves across the bank's coverage, takes up reserve / loan ratios by a median 17bps, and takes down 1Q20 EPS by about ~1/3. That said, banks may well opt for a higher charge, especially if they are looking for a slower economic recovery than we are.


At the macro level, analysts will want to know how high bankers expect unemployment to go, how that will affect consumer loan delinquencies, and how much exposure they have to oil companies and sectors that have seen business vanish, like airlines, hotels and restaurants. And they will also inquire about how effective government stimulus programs have been, and why so many banks have been leery of participating in the PPP small business rescue program.

Spending by the Federal Reserve and Treasury Department could keep loan losses from being as high as in prior recessions, said Wells Fargo bank analyst Mike Mayo. He described the first quarter as the most difficult one to predict since the peak of the global financial crisis in late-2008.

“You have the biggest accounting change to impact loan loss reserving coming in the quarter that needs the biggest change in loan loss reserves,” he said.

The three most important things to watch for with bank earnings will be “credit, credit and credit,” Mayo told Bloomberg last week in a phone interview. “Investors want to know about impacts to industries,” including credit draw-downs, losses and provisions. They’ll also want to hear about the degree of relief banks are offering borrowers, particularly regarding small business lending and mortgage forbearance, he said.

“The only line items bank investors will care about this season are the ones pertaining to credit,” with provisions and net charge-offs determining how bank stocks will trade, Vital Knowledge founder Adam Crisafulli wrote in a note. Commentary about capital return will also be key, he said, as “investors assume buybacks will be resumed in the second half (they’ve been voluntarily suspended until the end of June) while dividends continue.”

Comparing results with expectations will be particularly challenging this quarter, Cassidy said, as analysts and investors alike will be “in the dark” on first-quarter and full-year earnings estimates, due to the difficulties in assessing the collapse in the U.S. economy from containing Covid-19 and the impacts from CECL.

“Missing first-quarter EPS estimates by 20%-30% is not likely to be a big deal but posting a meaningful bottom line loss due to a significant increase in the loan loss provision would be a cause for concern,” Cassidy said.

Going back to the banks reporting tomorrow, JPMorgan is likely to “once again weather the storm better than peers given its diversified franchise and risk management prowess,” Barclays analyst Jason Goldberg wrote in a note.

Relative to the prior quarter, Goldberg expects a larger balance sheet, driven by draw-downs and deposit growth; lower net interest rate margin, or NIM; seasonally higher fee income from trading; greater costs and a higher loan loss provision, along with more mortgage volume. In credit cards, he sees continued year-over-year growth, but also reserve build. Other key factors Goldberg will watch include Dimon’s health, the outlook for trading and expenses, and strategies for consumer branches and credit cards.

One final point: heading into earnings, JPMorgan quietly announced it would "temporarily" halt the issuance of new loans and would substantially hike its mortgage lending standards - minimum FICO score of 700, minimum down payment to 20% – for one simple reason: to limit exposure to the coming default wave that will cripple small and medium business and devastate household income for quarters to come. Anything that Dimon says to twist that JPM is hunkering down ahead of what Bloomberg called the "Biggest Wave Of Defaults In History" will be nothing more than self-serving spin.