The banks are stronger than you think

Concerns over financial-sector earnings might be overblown.

By Anthony Mirhaydari Jul 16, 2010 3:06PM

Megabanks JPMorgan (JPM), Citigroup (C) and Bank of America (BAC) have all reported better-than-expected earnings results this week -- only to be knocked to the ground by unimpressed investors. The problem is that the earnings beats are being driven by reduction in loan-loss provisions, which are like accounting piggy banks that are used to protect against defaults.

 

An optimist would say that these reductions are a result of a strengthening economy and improvements in the number of people who can pay their loans on time.

 

But the skeptics are having none of it. Bank stocks have tumbled over the past two days on concerns that bank executives are using creative tactics to dress up their earnings -- prematurely tapping into their credit reserves. So who's right?

 

On the plus side, check out the way that loan charge-offs are declining: Quarter over quarter, they fell $1.2 billion at Bank of America, $422 million at Citigroup and $2.2 billion at JPMorgan.

And the trends are expected to continue as job creation ramps up. On Thursday, initial weekly jobless claims fell to 429K from 454K previously -- falling out of a range between roughly 450K and 500K that the metric has been stuck in since October.


But there are also big negatives. Revenues are falling: The top line dropped 7.6% year over year at JPMorgan, 33.3% at Citigroup and 11% at Bank of America. And of course there are worries over the hit to profitability related to the passage of financial regulatory reform legislation in Washington.

 

XLF

 

As a result, you can see in the chart above how bank stocks have failed at triple top resistance that has contained the Financial SPDR (XLF) since May. And this underperformance by the financials is what's dragging down the broad market.

 

Are the concerns valid? Or is this another example of excessive pessimism?

 

I think there is some reason for optimism. The decline in loan losses is an unmitigated positive. And the decline in revenue might be due to some shrewd prepositioning by executives to protect themselves against an increase in interest rates. Analysts at FBR Capital note that JPMorgan shortened the average maturity of its securities portfolio. Translation: The bank is selling long-term Treasury bonds and buying more short-term Treasury bills instead.

 

That cuts the losses the bank will take on its portfolio should the economy continue to improve and the Fed starts raising rates. This is exactly the right step to take and will help boost profitability into the future. This is because the value of long-term bonds drop more severely than short-term bonds as rates rise.

 

And as for the hit from regulatory reform, I think it's already priced in. A recent Citigroup analysis of the legislation found that under very conservative assumptions, Bank of America would see earnings per share fall 16% while JPMorgan would suffer an 18% impact. From the April high, Bank of America has dropped 28% while JPMorgan is down nearly 19%.

 

The XLF is likely destined for a test of support near $13.75 -- or another 3% drop from here. But I think buyers will come in there, and form an inverse head-and-shoulders reversal pattern. Once the XLF moves through what would be the neckline at $15, I'm a buyer.

 

Disclosure: The author does not own or control a position in any  company mentioned. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below. 

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