Big 4 Bank Earnings: The Gift of Low Expectations (Update 1)

Updated from 8:13 a.m. ET with additional detail on revenue and earnings comparisons for the "big four" U.S. banks.

NEW YORK ( TheStreet) -- If there is one silver lining for banks this earnings season, it is the fact that expectations are pretty low.

That should prevent any nasty surprises for shareholders when banks report their third-quarter results in the next couple of weeks.

Analysts have already slashed estimates ahead of third-quarter earnings announcement, factoring in substantially weaker trading revenues, the meltdown in mortgage refinancing volumes, tepid loan growth, flat net interest margins and for some banks, particularly JPMorgan Chase ( JPM), higher legal costs.

According to the Financial Times, more than $1 billion has been wiped off earnings estimates for Wall Street's five biggest banks in the past month.

Bank stocks have also underperformed in recent months , although year-to-date, the KBW Bank Index still outpaces the broader S&P 500.

Sentiment has changed since the beginning of the year when the revival in housing and the overall improvement in the economy buoyed bank stocks, even though earnings estimates had not really changed.

Investors were betting that an improving economy will lead to higher interest rates which would in turn lift bank profitability.

But with the Federal Reserve deciding to continue bond purchases instead of tapering the program, the outlook for a rise in short-term rates has dimmed, quashing expectations for an expansion in net interest margins or NIMS.

Net interest margin is the spread between the average interest earned on loans and investments and the average interest paid on deposits and borrowings. For so-called asset sensitive banks, rising interest rates are an advantage as banks can raise interest rates more quickly on loans and investments, while their cost of borrowing adjusts with a lag.

Not only are margins likely to remain flat or slightly lower for most banks, loan growth has been disappointing amid a lackluster economic environment.

The rapid rise in interest rates since May has crushed the mortgage refinancing market. JPMorgan CFO Marianne Lake has said the bank expects its mortgage origination business to make a loss in the third quarter.

Wells Fargo ( WFC) also said that it is cutting jobs to adjust to the lower volumes as refinancing activity shrinks. It has announcd 4,800 layoffs so far this quarter.

Meanwhile, activity outside of mortgage banking is not doing any better. The latest loan data from the Fed suggests weakness in commercial and industrial loan growth compared to last year.

KBW analysts expect sequential loan growth of just 0.1% on an average.

While the big universal banks with large capital markets businesses have typically relied on trading revenue to boost profits when loan growth is weak, they can't count on that offset this time.

"We suspect several banks were on the wrong side of the QE3 tapering trade in 3Q," Goldman Sachs analysts wrote in a recent report. The analysts expect revenues from fixed income, currencies and rates to fall 30% year-over-year.

It has also been a quiet quarter for investment banking.

So where are the profits going to come from? The usual suspects: loan loss reserve releases and cost cuts.

Improving credit continues to be a strong theme for many banks, with JPMorgan indicating that it could release another $1.5 billion in reserves in the third quarter.

Reserve releases are also likely to be a strong theme for Citigroup ( C), which continues to wind down its non-core Citi Holdings arm.

But any earnings beat from greater-than-expected reserve releases will likely be viewed as a low-quality one, as such releases are seen as an accounting move.

The other lever for banks seeking to boost profits is cost cuts. This is a big theme for Bank of America ( BAC). Shares of Bank of America have held up relatively well compared to its peers in recent weeks.

Atlantic Equities analyst Richard Staite expects costs excluding litigation to fall 3% year-over-year at Bank of America, while Wells Fargo sees an increase of 1% and JPMorgan could see a 2% increase due to increased compliance costs. Meanwhile, he also expects revenues at the bank to fall only 1% year-over-year, compared to a 6% drop at Wells and a 3% decline at JPMorgan.

Raymond James analyst Anthony Polini is bullish on Bank of America for the same reason.

Shareholders are happy to see bank management focus on cost cuts as a way of boosting profits in a flat revenue environment.

But after years of expense reduction in the wake of the crisis, only a handful of banks really have room to cut costs without cutting to the bone.

Whether or not banks exceed earnings expectations, what long-term investors should be really looking for are signs of improving operating conditions. They are unlikely to see that this quarter. In fact, this is likely out of banks' control.

According to KBW's Mutascio, the usual catalysts for banks such as loan growth, higher margins, return of capital and so on are right now depressed due to poor economic conditions.

"It feels like the historical progression of catalysts for the banks of 1) improving credit quality giving way to increased loan growth and then 2) an improving economy resulting in higher short-term rates and NIM expansion has broken down -- at least for the time being," he wrote.

The fate of the bank stocks, he argued, might now be tied more directly to the macro-economic environment. "A breakout of the GDP malaise could allow for further multiple expansion and outperformance. Conversely, it is hard for us to envision further outperformance at these levels if economic growth remains sluggish -- leading to tepid revenue growth and EPS growth that is driven more by non-cash loan loss reserve releases than it is by pre-tax pre-provision income growth," Mutascio added.

JPMorgan Chase and Wells Fargo kick off earnings season on Friday, with Bank of America and Citigroup reporting the following week.

JPMorgan is usually the bellwether for the bank sector, though this time the focus is likely to be entirely on its legal problems. Still, it should offer cues for the others.

The bank is expected to report third-quarter earnings of $4.848 billion, or $1.23 per share, according to analysts polled by Thomson Reuters. In comparison, the bank earned $1.60 a share during the second quarter, and $1.40 a share during the third quarter of 2012. JPMorgan's revenue is expected to decline to $24.059 billion during the third quarter from $25.958 billion the previous quarter and $25.863 billion a year earlier.

Wells Fargo is forecast to post third-quarter earnings of $5.197 billion, or 97 cents share, compared to 98 cents the previous quarter and 88 cents a year earlier. The consensus third-quarter revenue estimate is $21.000 billion, declining from $21.378 billion in the second quarter and $21.213 billlion in the third quarter of 2012.

For Bank of America, analysts estimate third-quarter earnings will come in at $2.242 billion, or 18 cents a share, compared to 32-cent profit during the second quarter and a break-even third quarter of 2012, when debit valuation adjustments and several one-time items wiped out earnings. The consensus third-quarter revenue estimate is $22.082 billion, compared to $22.727 billion the previous quarter and $20.428 billion a year earlier.

Citigroup's consensus third-quarter earnings estimate is $3.267 billion, or $1.06 a share, compared to $1.34 a share in the second quarter, and 15 cents a share in the third quarter of 2012, when the company booked a $2.9 billion after-tax loss on the valuation of its share of the joint brokerage venture with Morgan Stanley ( MS). Citigroup's revenue for the third-quarter is projected to total $18.828 billion, down from $20.479 billion the previous quarter, but up considerably from $13.951 billion a year earlier, which included a $4.7 pretax hit from the write-down of Citi's share of the joint venture, which the company was preparing to sell to Morgan Stanley.

-- 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

Flashback Friday: Amazon, Chip Stocks, Memorial Day

Flashback Friday: Amazon, Chip Stocks, Memorial Day

Week Ahead: Wall Street Looks to Jobs Report as North Korea Meeting Less Certain

Week Ahead: Wall Street Looks to Jobs Report as North Korea Meeting Less Certain

Dow and S&P 500 Decline, Energy Shares Fall as U.S. Crude Oil Slides 4%

Dow and S&P 500 Decline, Energy Shares Fall as U.S. Crude Oil Slides 4%

Replay: Jim Cramer on the Markets, 10-Year Yield, Oil Prices and Foot Locker

Replay: Jim Cramer on the Markets, 10-Year Yield, Oil Prices and Foot Locker

UAW Officially Files Complaint on Tesla Thanks to CEO Elon Musk

UAW Officially Files Complaint on Tesla Thanks to CEO Elon Musk