Bank's Earnings Will Be All About Outlook

NEW YORK ( TheStreet) -- When JPMorgan Chase ( JPM) and Wells Fargo ( WFC) kick off bank earnings season on Friday, all focus is likely to be on how rising interest rates have affected their outlook for the second half of 2013.

Analysts expect banks to report a reasonably good quarter when compared to the second quarter of 2012, which was a tough trading quarter for the big banks, especially JPMorgan, which was hit by the "London Whale" derivative trading losses.

The consensus estimate among analysts polled Thomson Reuters is for JPMorgan to report earnings of $1.44 a share on revenue of $24.84 billion. The bank reported earnings per share of $1.21 on revenue of $22.89 a year earlier.

Wells Fargo is forecast to post earnings of 93 cents a share on revenue of $21.22 billion. In the year-ago quarter, the bank reported EPS of 82 cents on revenue of $21.29 billion.

Still, a sharp and sudden rise in interest rates late in the second quarter after the Federal Reserve indicated that it may wind down its big bond purchase program has jolted expectations.

"This won't be a blowout quarter," KBW analyst Chris Mutascio told reporters in a presentation on Tuesday.

The market rate on10-year U.S. Treasury bonds rose from a low of 1.63% on May 2 to a high of 2.74% on July 5. A sharp rise in long-term rates has an effect on many facets of the banking business, including mortgage production, fixed income trading and bond portfolio valuation.

While analysts had already begun to factor in slowing mortgage banking income for banks as the refinancing boom tapers, the volatility in fixed income trading and the impact of rising rates on bond portfolios of banks have caused analysts to adjust second-quarter estimates more recently.

Trading volumes were likely strong, but banks may have had to mark down their portfolios to reflect the impact of rising rates.

Unrealized gains on "available-for-sale" securities dropped by more than $20 billion through June on a net aggregate basis, according to FBR Capital analyst Paul Miller. This won't affect earnings but could result in a 1% to 2% hit to book value, which could be a negative for banks lean on capital.

Much of the impact of higher rates could be reflected in banks' results during the second half of 2013. Analysts are expecting a slow summer for capital markets activity, with debt underwriting falling sharply following rate hikes.

Analysts will be looking for commentary from executives on mortgage banking revenue. Rising interest rates have already sharply slowed refinancing activity, as reported by the Mortgage Bankers Association. Purchase applications have mostly held up, but with refinancing accounting for more than 70% of production, loans for home purchases are unlikely to prove an adequate offset.

Banks with significant mortgage loan servicing assets, such as Wells Fargo, may have some cushion from falling production. Rising rates reduce prepayment risk and lengthen the average life of a mortgage in a portfolio, which means servicers can expect steady cash flow for a longer period. As a result, servicers will see a boost from a "write-up" of servicing rights.

Management outlook for loan growth and loan pricing should also be a talking point in the backdrop of rising rates.

Bank stocks have outperformed the overall market in the last several months, buoyed by an improving economic outlook and the housing recovery. Rising interest rates are also thought to benefit bank stocks in the long run, as banks can get a better rate on their loans and investments.

However, the market reaction will depend upon how fast rates rise and to what level. Mutascio also noted that although rising interest rates are a positive, most banks are levered to short-term rates which are likely to remain low for a prolonged period of time. It is the long-term rates that are rising.

As a result, banks that can benefit most from the way the yield curve is currently steepening are those that have a lot of liquid assets and those that have bond portfolios that have short maturity schedules. JPMorgan Chase, according to Mutascio, is among the best placed to benefit.

Outside of earnings, both banks are likely to be questioned on their capital levels, in light of recently proposed rules that doubled the minimum Basel 3 Supplementary Leverage ratio from 3% to 6% for large bank subsidiaries, while the holding companies have a proposed minimum requirement of 5%. Wells Fargo is expected to already meet the requirement, but JPMorgan may face a shortfall, according to analysts.

Given that the rules were issued only this week, the banks are unlikely to comment on specific numbers.

Analysts would however expect them to shed light on whether the new rules would change their capital deployment plans. If banks have to raise more capital, they might limit their dividend payouts or share buyback plans. Of course, banks' ability to pay out capital is still determined by the Federal Reserve.

After the tearing run bank stocks have had over the past year, valuations for bank stocks are no longer cheap on a price-to-earnings basis. Management will have to walk a careful line in setting up expectations.

With so few things under their control, expect banks to continue to talk about tightening expenses as a way of riding through a volatile environment.

-- Written by Shanthi Bharatwaj in New York.

>Contact by Email.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

More from Stocks

Dow Tumbles as Trump Ratchets Up China Trade Fight

Dow Tumbles as Trump Ratchets Up China Trade Fight

This Should Be Your Retirement Savings Plan When the Stock Market Crashes

This Should Be Your Retirement Savings Plan When the Stock Market Crashes

TheStreet's Top Columnists Take Your Questions on What Stocks to Buy

TheStreet's Top Columnists Take Your Questions on What Stocks to Buy

Is Tesla Really Being Sabotaged?

Is Tesla Really Being Sabotaged?

Beware of the Coming Economic Debt Bomb

Beware of the Coming Economic Debt Bomb