Take Banks’ Earnings With A Grain Of Salt

US earnings season is upon us. Numbers for the majority of the financial institutions are out and have well exceeded analysts’ expectations. Wells Fargo (WFC) kicked off the season in early April with record earnings. Goldman Sachs (GS) followed suit with a net income rise of 20%. Next was J.P. Morgan (JPM) with record revenue and earnings above expectations. Finally, Bank of America (BAC) posted a $4.2 billion profit for 1QFY09 yesterday.

Looking more closely at the results, an increase in the investment banks’ capital markets businesses have offset the continued deterioration in commercial banking, credit-card and mortgage businesses. Goldman’s strong results were driven by a surge in its F.I.C.C. (fixed-income, currency and commodities) division. Investment banking revenues were 30% lower than Q1FY08 and the asset management division fell 29% YoY. The bank continued to take write downs on its real-estate exposure. JP Morgan’s results were similar, with strong bond and trading activity. It logged $10 billion in credit losses for the quarter. The credit card business saw a surge in defaults to 7.72% from 5.56% in Q4FY08. Likewise, it marked down its portfolio of leveraged loans by $711 million and mortgage-related exposure by $214 million. BofA’s earnings painted a similar story. The company’s $4.2 billion profit for the quarter was driven by its capital markets division and a $2.2 billion mark-to-market accounting provision. However, its retail and commercial banking, credit-card and mortgage businesses continued to deteriorate. Credit cards posted a $1.8 billion loss from a previous profit of $867 million. Losses increased to 8.62% from 5.19% of total nonperforming assets. Likewise, earnings in retail were halved from a year ago.

Initial investor enthusiasm over the financials reports were muted yesterday on BofA’s announcement. A closer look at the numbers calls into question the sustainability of these earnings. It makes sense that the driver of these earnings would be the capital markets divisions. The banks are essentially borrowing for free (from government initiatives) and lending out at extraordinarily high rates. Hard not to make a profit on these lending practices. Indeed, Jamie Dimon stated in JPM’s earnings call that fixed-income activity is likely to taper off “and it’s not reasonable to expect it to continue at that level.” What should be scrutinized from these reports is the commercial banking, credit-card and mortgage businesses. These are a gauge of the strength of the consumer and an indicator of general economic health. Therefore, using the banks’ earnings at face value as a sign of sustained economic recovery is likely a mistake.

GS & AIG

Saving AIG (AIG) was never about AIG. Nearly every company in the financial services industry held CDS on other institutions through AIG. A failure of AIG would render these contracts useless and do unspeakable things to the banks’ balance sheets. Goldman was one of AIG’s largest CDS counterparties on mortgage-related products insurance. A government-backed vehicle recently purchased the distressed securities underlying AIG’s CDS contracts at full-value. Goldman Chief Financial Officer David Viniar has repeatedly stated the AIG payout had no material effect on their first quarter bottom line. First off, I find that hard to believe.

Second, Viniar has repeated that GS almost completely hedged its exposure to AIG (presumably by being short the equity). GS received $14 billion for its assets through the AIG program, when the assets had a market value of just $8 billion. If the market was able to run its course on GS’s hedge (profiting as the equity went to nearly zero), it makes little sense for them to be made whole on the other side. While Goldman’s F.I.C.C. division (where the AIG profits would materialize) well exceeded expectations for the quarter, investment banking, equities trading, asset management and securities services all fell below the consensus.

It is important to take these earnings with a grain of salt and scrutinize the business of these large institutions to analyze whether these profits are real or simply “fake.”

Disclosure: The Fund the author is associated with is long JPM and GS

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