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Investors unimpressed by strong US bank earnings

Investors focus on exposure to oil; banks see no contagion yet.

Jamie Dimon serious-R-600

JPMorgan chief executive Jamie Dimon

US banks reported this month stronger-than-expected revenues and much better profits for the fourth quarter of 2015, showing that pro-longed cost-cutting efforts have left them resilient earners.

As they now hope finally to emerge from an era of large regulatory fines and legal bills, banks could become once again a useful payer of dividends to investors.

For the full year 2015, JPMorgan delivered its record net income of $24.4 billion. Bank of America produced its best profit since before the financial crisis, at $15.9 billion. Citigroup brought in $17.1 billion of profit for 2015, its best result since 2006.

Shareholders – and the analysts who had failed to predict these strong results – reacted in quite predictable fashion. They dumped the banks’ stocks.

Citigroup’s share price fared worse, falling 7% after results and dragging the bank’s market valuation down to just 0.7 of tangible book value per share. JPMorgan’s stock fell a more measured 2.5% and Bank of America’s fell just 2%.

However, even stock-market darling Wells Fargo saw its share price fall by 5.5% in the days after it announced $23 billion in net income for 2015, a year in which, after 13 consecutive quarters of declines in non-performing assets, it generated so much capital that regulators allowed it to return around $3 billion in dividends and stock buy-backs each quarter.

In part, the banks simply got caught up in the general stock market sell off at the start of the year, amid fears over slowing Chinese and global growth and further possible declines in the oil price.

The International Energy Agency (IEA) estimates that weakening growth will subdue demand for oil, even as Iran returns to an already over-supplied market as a big producer. It sees supply exceeding demand by 1.5 million barrels per day in the first half of this year, with global inventories rising to a notional 1.285 billion barrels and straining storage infrastructure.

As the oil price fell below $30 per barrel in January, analysts began to predict further declines to $25 or $20.

“Unless something changes, the oil market could drown in over-supply,” says the IEA. “So the answer to our question [can the price fall even lower] is an emphatic yes.”

Investors are focusing on banks’ exposure to the oil and gas sector, as well as to second-order effects on other types of credit. JPMorgan reserved $550 million against exposure to the oil and gas sector in 2015 and expects to add more in 2016.

New credit crisis

Analysts are starting to worry that, as companies have leveraged up once more to reward shareholders with the benefit of cheap debt, a new credit crisis is upon us and that banks might not be building reserves fast enough.

JPMorgan chief executive Jamie Dimon told analysts: “You know me, I’d put up more if I could but accounting rules dictate what you can do.”

Dimon seemed to suggest that banks would almost be compelled to keep lending to oil companies to prevent a crisis as other market sources of funding disappear.

“The oil folks have been surprisingly resilient,” says Dimon. “Remember, these are asset-backed loans. A bankruptcy doesn’t necessarily mean your loan is bad.”

He admits: “If banks just completely pull out of markets every time something gets volatile and scary, you’ll be sinking companies left and right.”

If the stresses now hitting the oil and gas and metals and mining sectors are the canary in the coal mine, JPMorgan isn’t sucking gas just yet, according to chief financial officer Marianne Lake.

“We’re watching very closely industries that could have knock-on effects like industrials and transportation, but we’re not seeing anything broadly in our portfolio right now,” she says.

Citigroup might be, though. More exposed than its peers to emerging markets – which the World Bank suggests suffered their weakest growth since 2001 last year, and where it fears spillover risks in 2016 from weak growth or recession in Brazil, Russia, South Africa and China – Citigroup built $300 million in reserves related to oil and gas in the last quarter of 2015.

Mindful of second-order effects, it built another $300 million across the rest of its portfolio and predicts credit costs in its wholesale business of $600 million for the first half of this year. And that is based on oil at $30 per barrel.

John Gerspach, Citigroup’s chief financial officer, admits: “If oil were to drop to say $25 a barrel and then stay there for a sustained period of time, then that first-half cost of credit number that I gave you [$600 million] might double.”

Citigroup’s overall exposure to the oil sector, including funded loans and unfunded commitments, is $58 billion, with 80% of that to companies for now-rated investment grade.

Bank of America chief financial officer Paul Donofrio says that while the bank has $21 billion of utilized exposure to the energy sector, that represents just 2% of total loans, and of that $21 billion just $8.3 billion is to borrowers in the two high-risk sectors of exploration and production and oil field services.

The bank has reserves on those exposures of $500 million and believes that if oil stayed around $30 per barrel for nine quarters, losses would be about $700 million.

“Outside of energy, we are not seeing asset-quality change nor are we seeing a reduction in appetite for our credit,” says Donofrio.

The banks are desperately trying to make the case that if the oil price falls simply because of over-supply – and not because of more worrying collapse in demand – then contagion will not spread form the oil sector and that other sectors might well benefit.

Their problem is that the market just doesn’t buy it.

“We estimate that US high-yield market is pricing a 6.1% default rate in 2016 versus a current default rate of 3.2%,” says Alberto Gallo, head of global macro credit research at RBS. 

“However, defaults could spread beyond the energy sector, into retail and manufacturing – each 5% of the US high-yield market. We estimate that 10% of high-yield manufacturing firms have exposure to the energy sector.”

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