The economic pounding being meted out by the drastic global response to the Covid-19 pandemic was hard to spot in the first-quarter results from the biggest US corporate and investment banks released in April.
Rarely can there have been such a wide gulf between the performance of parts of banking, where trading and debt issuance revenues soared, and the dire underlying economic reality now gripping the corporate world.
So far, the bridge across that gulf has been government and central bank support on a scale never seen before. But that cannot last – and banks know it.
“The outlook is much more important than the last couple of months,” said Morgan Stanley chief executive James Gorman on his earnings call on April 16.
And that outlook is grim.
Look below the surface of some of the most striking numbers – the record investment-grade bond volumes, the extraordinary sales and trading results, an outstanding quarter for Citigroup – and the signs are ominous. As talk in many economies turns from short-term lockdowns to long-term adjustments to a new and unpleasant normal, early signs of a wave of future stress are emerging. And investment banks are having to prepare for life after a surge of volatility-fuelled trading and panic-driven issuance.
Loan loss provisions – set to be this crisis’s equivalent of the 2008 asset-backed securities write-down tally – are merely the most obvious way in which these signs are now evident in earnings statements. Mark-to-market losses on bridge financings are another.
Corporate deposits are also up, for the wrong reason, as companies that struggled to access commercial paper when that market froze mid-way through the quarter drew on revolvers instead – and could do nothing braver with the money than put it on deposit at those same lenders. At Bank of America, some 75% of loan draws not used for paydowns elsewhere came straight back to the bank.
Strategic pipelines are looking shaky as mergers and acquisitions and IPOs are put on hold. Market volatility might have helped traders, but it has played havoc with asset-management divisions.
"None of the scenarios we are looking at are anything other than a recession"- Paul Donofrio, Bank of America
For some firms fund outflows in March wiped out inflows in January and February. Securitized products and municipal securities have been particularly badly hit by dislocation. After record levels earlier in the quarter, prime-broking balances cratered in late March.
Although the crisis has played out in markets, however, its real nature is closer to home for individuals. “This isn’t a financial crisis; it’s a public health crisis with severe economic ramifications,” said Mike Corbat, chief executive of Citigroup, on his bank’s earnings call – and his peers have echoed this view.
Bank of America’s vast reach makes it an extraordinary gauge of conditions on the ground in the US. The bank had received one million requests for assistance by early April. More striking still was its view of the flows of cash in the economy, whether by withdrawals at ATMs or cheques, credit and debit cards. In January and February, that was running at about $65 billion a week, according to chief executive Brian Moynihan. By mid April it was closer to $50 billion, but the rate of decline was flattening.
Events are moving fast. In JPMorgan’s view, economic prospects in the US worsened so sharply at the start of April that it almost doubled its already awful assumptions of falling second-quarter GDP and rising unemployment in the few days between the bank closing its books for the first quarter and CFO Jennifer Piepszak presenting those earnings to analysts on April 14.
Jennifer Piepszak, JPMorgan
She said that while the bank’s economists had been expecting a 25% fall in US GDP in the second quarter, this had now been revised to 40%. Unemployment was now expected to be 20% instead of 10%.
These are sobering numbers, even factoring in their accompanying expectations of a strong recovery in the second half of the year. The Great Depression of the 1930s saw US unemployment hit about 25%. The 2008 financial crisis saw it peak at 10%.
The changed assumptions are also getting closer to an extreme adverse scenario described by JPMorgan’s Jamie Dimon in his annual chairman’s letter, published on April 6.
This envisaged a 35% drop in GDP in the second quarter, lasting through the end of the year, and unemployment peaking at 14% in the fourth quarter.
That Piepszak stressed this was not JPMorgan’s central case was scant consolation, as it gives a flavour of what the bank is preparing for.
She said that Dimon’s extreme example envisaged 2020 credit costs for the bank of more than $45 billion. To compare that with an earlier crisis, the five quarters from the fourth quarter of 2008 to the fourth quarter of 2009 saw credit costs of $47 billion.
Bank of America CFO Paul Donofrio told analysts that he was envisaging a big drop in US GDP in the second quarter, and then negative GDP growth to continue well into 2021, possibly to the end of the year.
“None of the scenarios we are looking at are anything other than a recession,” he said.
The increased reserves and some markdowns fed into a 3% year-on-year decline in group revenues at JPMorgan, which fell to $28.2 billion.
At Goldman Sachs and Bank of America, revenues dropped 1% to $8.7 billion and $22.8 billion respectively, while at Morgan Stanley they fell 8% to $9.5 billion.
Citigroup, bolstered by a strong sales and trading performance as well as mark-to-market gains on loan hedges, saw a remarkable 12% rise in revenues to $20.7 billion. And the bank also notched up leading increases in corporate and investment bank profits as well as revenues in advisory and sales and trading.
Early in the 2008 financial crisis, it was write-downs of asset-backed and mortgage-backed securities and their derivatives that quickly became the statistic for bank-watchers to tally. This time around it will be increases in credit reserves and markdowns in loan portfolios and bridge books.
Economic outlook revisions of the sort revealed by JPMorgan mean that reserves that looked prudent in the first quarter are very likely to be outstripped by what is to come.
Piepszak said that reserve builds over the next few quarters would be “meaningfully higher” than in the first, despite the fact that JPMorgan’s loan portfolio was more prime than the Street average.
At Bank of America, Donofrio took a more literal approach, telling analysts who wanted colour on future reserves that “if we thought we were going to have to add more reserve build in the future, we would have put it into this quarter. That’s how the rules work.”
That said, he added: “When we get to the end of the second quarter, we may have a different view of the future.”
Coronavirus-related reserve increases are coming on top of what had already been a big one-off slug of extra reserves applied at US banks on January 1 as a result of the adoption of current expected credit losses (CECL), a new accounting standard that recognizes upfront a loan’s expected losses to maturity and that will also complicate crisis-related reserve assessments.
Banks had only just got to grips with a new approach based on what was a reasonable set of expectations on January 1; now all that has gone out of the window.
“The range of potential outcomes is the widest I’ve seen in quite some time,” said Morgan Stanley CFO Jonathan Pruzan, with considerable restraint.
Adding to the difficulty of assessing the future is that, for all the market dislocation seen in March, quantifying where and by how much credit quality will suffer is still largely guesswork.
“There’s no evidence right now that you can point to of asset degradation,” said Donofrio. “So, we are all doing this based upon just our view of the future based upon all those inputs that we use in our models.”
Happily for the big banks required to implement CECL in 2020, the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation on March 27 announced a new interim final rule that delayed the impact of CECL on regulatory capital for two years, with a three-year transition period after that.
This matters because CECL reserves do not count towards either common equity tier-1 (CET1) or additional tier-1 capital but only to tier-2, and then subject to a cap.
At JPMorgan, the first-quarter net reserve build of $6.8 billion (to $25.4 billion or 2.32% of total loans) was a 37% increase on the firm’s January 1 credit loss allowance. Some $3.8 billion of the new reserves have come from the credit card business and $2.4 billion have come from wholesale, particularly in relation to consumer and retail but also to oil and gas.
The bank also recorded bridge book markdowns of $896 million, as well as a $951 million hit in corporate and investment banking from the widening of funding spreads on derivatives.
Piepszak’s calling-out of oil was timely. Less than a week after JPMorgan’s earnings call, the price of West Texas Intermediate (WTI) on the last day of dealings for delivery in May turned negative for the first time on April 20 as storage was expected to be almost impossible to find.
At that time the June delivery had been holding at around $25 a barrel, although the next day it too dropped sharply, but remaining in positive territory. Piepszak said that JPMorgan’s assumption was that WTI would remain below $40 until the end of 2021.
Bank of America’s total credit reserves rose 27% from January 1, to $17.1 billion. Loan and lease loss reserves now account for 1.51% of the portfolio, up from 1.27%, while the reserve for unfunded lending commitments rose 21% to $1.4 billion.
The bank also recorded some $450 million of net markdowns in its investment bank related to loans and underwritten commitments held at fair value, as well as about $500 million on derivative positions and non-core securities within global markets.
Citigroup said credit reserves were up 23% from January 1, to $22.7 billion, with loan reserves at 2.91% of the portfolio. Some $2.3 billion of the increase came from consumer, with $1.4 billion from wholesale. Reserves for unfunded commitments rose by $500 million to $1.9 billion.
Reserves are less of an issue for the old broker-dealers Goldman Sachs and Morgan Stanley, although Goldman is building a consumer business and so is having to provision accordingly.
It saw quarterly provisions rise more than four times year on year, to $937 million, taking total credit reserves to $3.2 billion, compared with about $1 billion at the end of 2019. The bank said its increased provisions related to growth in corporate and credit card loans, and they were the result of the Covid-19 crisis and turbulence in the energy sector.
Goldman took a hit of about $500 million related to derivative valuation adjustments in its markets business. And there were undisclosed fair-value markdowns on acquisition finance commitments.
But it also saw $500 million of markdowns on its $2 billion public equity portfolio, including a $180 million loss related just to Avantor.
In addition, it posted $500 million of markdowns on its $19 billion private equity portfolio, spread over some 280 names, and there were also marks on the debt portfolio. All told, the asset-management division posted revenues of negative $96 million, compared with a positive $3 billion in the previous quarter.
At Morgan Stanley, there were new loan loss provisions of $388 million, of which $273 million related to its $49 billion portfolio of held-for-investment loans and $115 million to unfunded lending commitments. It also booked $610 million of mark-to-market losses in its $47 billion held-for-sale portfolio.
The firm labelled the credit deterioration as “notable”. But it thinks stressed sectors account for only about $11 billion of its $108 billion corporate book.
With no exposure to credit cards or unsecured credit, Morgan Stanley has nothing like the reserve requirements of JPMorgan or Bank of America. And its retail and wealth businesses are exposures of high credit quality. But it did have one more blip: a $700 million loss involving falls in investments related to deferred cash compensation schemes.
Reserves and markdowns hit pre-tax profits at all five banks. Morgan Stanley’s 27% year-on-year fall was the best of the lot. Bank of America, Citigroup and Goldman Sachs dropped by about 50%. At JPMorgan, profits fell by 72%.
Good, then bad
Until markets seized up in March, things had been going well for the big US banks. January and February had been good, with risk assets looking buoyant and markets rising.
Capital markets issuance was strong, trading was profitable and flows were good on the asset management side.
March was a different story, with even short-term funding markets struggling to operate without wide-reaching government and central bank support. Clients cut risk and raised cash.
By that time JPMorgan had distributed some $8.8 billion in capital to shareholders, including $6 billion of buybacks. Like many other banks, it stopped doing that on March 15; and with distributions outweighing earnings and risk-weighted assets growing because of more lending and higher market volatility, capital ratios have fallen.
JPMorgan’s CET1 ratio fell to 11.5% at the end of the first quarter, down 90 basis points from the end of 2019. Bank of America returned $7.9 billion of capital to shareholders, with its CET1 falling 40bp to end the quarter at 10.8%. Citigroup’s CET1 was 11.2%, down 60bp, after returning $4 billion.
Morgan Stanley’s fell by 160bp to 15.3% and the firm repurchased $1.3 billion of stock. At Goldman Sachs CET1 fell by 140bp to 12.3% and the firm returned $2.4 billion to shareholders.
Situations like the current crisis are precisely why capital buffers exist, as JPMorgan’s Piepszak reminded anlaysts, and regulators have given banks flexibility to dip into those buffers.
JPMorgan’s CET1 ratio may fall below its 10.5% regulatory minimum. The extremely adverse scenario described in Dimon’s annual letter would see the bank end the year with a CET1 ratio of 9.5%, for example – at which point the board would consider suspending dividends. Below 10%, automatic restrictions on dividends and other payouts begin to take effect in any case.
JPMorgan approved more than $100 billion of new credit in March and saw corporate borrowers draw down more than $50 billion of their revolvers.
The start of the second quarter had seen a pause in those drawings, according to Piepszak, “but it could be just a pause”.
Bank of America saw commercial loans rise $67 billion, most of which was through drawdowns in March, of which over 90% was to investment grade clients. The first week of the month had looked normal, but drawdowns accelerated in the second week before peaking in the third. They had fallen in every week since then, said Donofrio.
Drawdowns totalled about $32 billion in the quarter at Citigroup, representing just over 10% of outstanding loans. Corbat said that the bank had seen very little of this activity as it entered the second quarter, however.
Morgan Stanley reported gross drawdowns of $13 billion, with a further $5 billion of new facilities. At Goldman the drawdowns totalled $19 billion, evenly split between investment grade and non-investment grade clients.
Demand for revolver drawdowns showed up in loan growth numbers and in other places too.
Companies drawing down revolvers, either because of worries that this liquidity might not be accessible if the crisis envelops the financial sector or to provide extra reassurance, are placing those drawn funds on deposit with those same financial institutions.
At Citigroup, some $92 billion of new deposits came into the corporate and investment bank in March alone, while the quarter saw an increase of $124 billion or 16%. About a third of that was from corporate clients who had either drawn down facilities or completed new issuance.
Goldman, which was already actively trying to build deposits as it rolled out both consumer banking and transaction services platforms, was able to report a $30 billion quarterly increase in total deposits, of which $12 billion were in consumer, a record for the firm. Commercial deposits in the transaction banking platform now total $9 billion and it is now serving more than 80 clients.
It was one of the more obvious ways in which Goldman – as might be expected – was looking to take something positive from the crisis. This was a point emphasized by chief executive David Solomon as he took the opportunity to reinforce his commitment to the medium and long-term goals set out at the firm’s investor day in January.
“Interestingly, this environment has created opportunities for us to accelerate our strategic plans in certain areas,” he told analysts on his earnings call on April 15, citing transaction banking and the acceleration of a strategic solution fund in its alternatives business, designed to help clients grab “attractive investment opportunities”.
Uncertainty around client intentions is hampering some of the opportunities that might arise from increases in client deposits.
Morgan Stanley is reluctant to deploy the excess deposits of its wealth clients who have shifted out of equities, for example. Deposits were up $45 billion in the quarter and $30 billion in March alone. While the firm expects that cash to be sticky for a while, Pruzan admitted he would need to wait to see how resilient it was.
The usual accounting gremlins that pop up in troubled markets are already making their presence felt. Revenues in JPMorgan’s lending business were up 36% year on year, but this was down to spread widening on loan hedges. Morgan Stanley also saw a gain from the same source, although it was booked through its sales and trading business. Goldman clocked up $375 million; Citigroup $816 million.
DCM and trading up
JPMorgan’s investment banking fees were up 3% year on year and the bank stayed top of rankings with a 9.1% market share. But there had already been some hurdles cropping up before the Covid-19 crisis began to bite. The bank’s 22% fall in advisory fees, for instance, was partly down to a strong quarter one year ago, but it was also because of more delays to regulatory approvals.
At Bank of America, total investment banking fees were up 10% and the number of transactions was up 9% despite of an industry fall of 20%.
Equity capital markets revenues were up across the board, except for a 1% fall at Morgan Stanley, but the year-on-year increase was partly a reflection of the US government shutdown that effectively closed new issue markets for 35 days at the start of 2019.
And banks warned that volumes would be muted for the rest of 2020, particularly for IPOs. Accelerated secondary deals could be an area of activity, however, as clients look to monetize holdings when short windows open.
One striking feature of the quarter, with the exception of a short period in early March, has been the very strong activity in investment grade bond issuance. Borrowers grabbed the opportunity to secure longer dated funding as short-term markets looked rocky and worries grew over a worsening of the crisis later. With $260 billion of deals, March was easily the busiest month on record.
JPMorgan reported its largest-ever quarter of investment grade debt issuance, leading $380 billion of deals, helping to drive a 15% year-on-year increase in debt underwriting fees, which topped $1 billion for the first time.
Bank of America’s $927 million wasn’t quite a record for the firm, but its 24% year-on-year increase was the biggest among peers. At Citi revenues fell 2% from a strong 2019 result.
Goldman Sachs and Morgan Stanley have much smaller DCM franchises, but they still posted increases of 21% and 10% respectively. Morgan Stanley took $70 billion of corporate and municipal debt to market in March alone.
In contrast to investment grade, it has taken far longer for high-yield markets to reopen as spreads widened; and that segment was largely shut at the end of the quarter after a strong start to the year. Banks are having to mark their outstanding bridge loan book accordingly.
Dimon has often made the point that the financial industry entered the coronavirus crisis in much better shape than it had entered the 2008 crisis, not least in terms of leveraged finance.
JPMorgan took an $896 million markdown on its firm-wide book of bridge finance commitments in the first quarter, which drove a 49% fall in investment banking revenues, even though investment banking fees were up 3% year on year.
But the bank’s bridge book of about $13 billion stands at about one quarter of what it was going into the 2008 crisis. It is also higher quality. And while the bank has had to mark down its commitments, it has no imminent closing deadlines, as Piepszak noted, meaning that there is no guarantee that the bank will have to realize those losses.
There may be grounds for that optimism given that Piepszak said there were already signs that the high-yield market would improve in the second quarter. Banks can also eat into fees before they take losses. And as Dimon noted, in the leverage finance business “every now and then you have a not particularly good quarter.”
Secondary markets businesses can be a great counter-crisis revenue engine; and so they are proving for those firms with sufficient scale, like the US investment banks. Before the coronavirus panic hit the US late in the first quarter, markets were already reacting to events elsewhere in the world. Investors were positioning themselves in response as well as in preparation.
"What you won't see banks do is price gouge, which you see in other industries"- Jamie Dimon, JPMorgan
The world looks a different place to when JPMorgan held its investor day on February 25, but back then the bank was already telling investors how well the quarter was going for its markets business. Since then there has been a correction in equity markets, a widening of spreads in debt markets and a spike in volatility in all asset classes, as well as a collapse in treasury yields and oil prices.
That adds up to record trading volumes: as early as January, volumes of rates and currencies trading were peaking at more than triple the average for that month, according to Piepszak.
Overall trading volumes in March were about 2.5 times average levels, according to Morgan Stanley’s Pruzan, and there were four times as many margin calls as usual. Bank of America handled $1.7 trillion of trades in one day and at one stage its global markets balance sheet was up $130 billion compared with the year end.
Industry-wide, global cash equities volumes rose about 50% year on year in the quarter.
Revenues are reflecting the trading surge. At JPMorgan fixed income was up 34% year on year, driven by rates, currencies and emerging markets. Equities was up 28% as client activity drove a strong equity derivatives result.
Bank of America had a record quarter in equities as revenues jumped 40% to $1.66 billion. Fixed income was up 13%, to approach record levels too. Citigroup’s 39% increase in fixed income was driven by rates, currencies and commodities, while the same rise in equities revenues was attributed to a strong quarter for derivatives.
Morgan Stanley saw a 29% gain in fixed income and 20% in equities. Fixed income was particularly strong in macro and commodities, and continues to benefit from years of work by the firm to rationalize that business. Commodities was strong as energy and metals prices swung.
The other side
Although different countries are at different stages of their coronavirus crises, the first quarter earnings of banks elsewhere are likely to follow the US sector’s playbook, with this first period dominated by immediate impact and response, occasionally strong trading activity and the navigation of policy measures.
But minds are already turning to the longer-term outlook, routinely referred to by the commentators as “the other side”, a term that captures the hope of an exit from crisis and the unknowable nature of that exit.
Here there are positive glimpses. For the moment the focus is on how banks are building reserves, but as Bank of America’s Moynihan notes, the important metric in the longer term might be pre-provision profits, “which we all learned after the last crisis”.
At Bank of America these were down just 5% year on year, which Moynihan argued was relatively strong given movements in rates and credit spreads.
What mattered was “how much capacity you have to keep generating capital and keep generating earnings that you can offset whatever comes at you, and that’s what we feel good about,” he said.
And market function and liquidity have now been essentially restored, according to Pruzan, itself a remarkable outcome so soon after companies found themselves unable to fund even through commercial paper, and reflective of the way in which authorities have run the 2008 crisis response in fast-forward.
Pruzan said that clients were now weighing how to look at unemployment and economic disruption in the context of the biggest monetary and fiscal actions in history.
It was a similar story at Bank of America, where Moynihan said clients’ attention was turning “from securing liquidity to a more structured view of their capital position and their needs to better understand how they prosper and fare in the Covid-19 impacted business model.”
For now, the emphasis is on individuals and companies, but in time the banking industry will also reflect on itself, and even for banks in as good a shape as the big US firms, there will be lessons to be learned. And as in 2008, the biggest of those may be related to lending and underwriting.
At Bank of America, Moynihan reckons discipline around his bank’s “responsible growth” mantra will stand it in good stead through the crisis, given that charge-off ratios at the bank have been lower than peers in six of the last seven years.
“For years now, we have been focused on client selection and getting paid appropriately for the risk we take,” he said. “What really impacts banks in a recession is not the loans put on your books during stress but rather the quality of your portfolio booked during the years leading up to stress.”
Evercore analyst Glenn Schorr put the question in blunt terms to JPMorgan’s Piepszak and Dimon: “Do you get paid enough for your balance sheet?”
For Piepszak, JPMorgan’s philosophy of taking a long-term franchise view on such matters had not changed, although “the marginal cost of new activity is higher for us right now.”
Dimon is banking’s biggest cheerleader and never more so than when the sector is under stress. He noted that new credit was being extended at different levels to the revolvers that were also being drawn, and that over time there would be a tightening of credit in the market.
But “what you won’t see banks do is price gouge, which you see in other industries,” he added. “Banks are very careful to support their clients in times like this.”
That may be so, but this support has so far been enabled by central banks and governments writing cheques that the world may struggle to cash as time goes on. A commercial shake-out must follow.
Banks will support their clients, but may have fewer of them when they get to the other side.