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Recovery buoys US banks

With the US economic recovery looking better entrenched than in other major developed economies, prospects for America's banks are improving
February 6, 2014

That banks do well when economic conditions improve is hardly rocket science. Such a backdrop tends to mean growing demand for credit and improving asset quality, all of which is good news for banks' earnings. So with economic recovery looking more entrenched in the US than in most other developed economies - the IMF believes the US economy will grow 2.8 per cent in 2014, compared to just 1 per cent for the euro area - then prospects for the US banking sector should be looking up. There was certainly evidence for that from last month's round of US bank fourth-quarter earnings releases.

Improving credit quality

Perhaps, most noticeably, the US banks are now seeing rapidly improving credit quality as better economic conditions take hold. That's partly down to such factors as a fall in US unemployment which, at just 6.7 per cent, is at its lowest rate for five years - leaving consumer borrowers more able to avoid default. At JP Morgan Chase (US: JPM), for example, provisions for credit losses dropped by a remarkable 93 per cent in the year to end-December. It's a similar story at the other big US lenders - Bank of America's (US: BAC) provisions, for instance, fell 56 per cent in the year, while Wells Fargo's (US: WFC) dropped 68 per cent.

"Credit quality improvements have been very strong," notes Erik Oja, US banks equity analyst at S&P Capital IQ - indeed, he thinks credit quality "is almost back to 2007 levels". That, in turn, has driven an impressive earnings recovery in 2013. For example, Bank of America's net income almost tripled last year, while Citigroup's (US: C) nearly doubled. Inevitably, though, such a writeback-driven boost will only be short term as credit conditions return to normal.

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Misconduct misery

But, despite increasingly benign conditions, the US banks do face a number of earnings headwinds. Most significantly, the banks are struggling with eye-watering charges for business misconduct issues - largely reflecting the mis-selling of mortgage-backed securities before the financial crisis. It's estimated that fines and settlements paid to US federal and state authorities cost banks more than $40bn (£24.5bn) in 2013.

Especially painful hits were felt by JPM. It paid out $13bn to a number of regulators in November relating to bad mortgage-backed securities sold to US government-controlled mortgage groups Fannie Mae and Freddie Mac. Elsewhere, Bank of America shelled out $11.6bn to Fannie Mae a year ago and potentially faces another $6bn fine from the US Federal Housing Finance Agency. Wells Fargo has agreed $869m in compensation to Freddie Mac, which could yet rise to $1.2bn. The banks have also been stung for compensation relating to improper mortgage foreclosure procedures - early last year, 10 lenders agreed a combined $8.5bn settlement.

But more pain could be on the way. "We're over half-way though the misconduct issues," believes Mr Oja. "But, while the claims from the government side may be largely over, [claims from] private investors are still going." JPM, for example, is rumoured to be nearing a $6bn settlement with institutional investors over mis-sold mortgage-backed securities. There are other threats, too. Just last month, JPM was forced to pay $2.6bn to settle criminal and civil charges relating to 2008's collapse of Bernard Madoff's Ponzi scheme.

Earnings headwinds

The low interest rate environment is a drag on earnings, too. While that's keeping funding costs low, such as the rates paid on retail deposits, lenders aren't always managing to deliver decent rates on their loan assets. Being required by regulators to hold more liquid, but low-yielding, assets hasn't helped, either. Accordingly, most banks reported that the already well-established trend of gradual margin attrition had continued during the fourth-quarter stage. Big names like Wells Fargo, US Bancorp (US: USB) and JPM all saw their net interest margin (the difference between its cost of funding and its loan rates) decline. Wells' experience was fairly typical, down 30 basis points versus 2012's fourth quarter to 3.56 per cent.

But there were some notable exceptions. Bank of America's, for instance, rose 21 basis points to 2.56 per cent - reflecting such issues as favourable market adjustments relating to mortgage-backed securities. Moreover, as US monetary policy is slowly tightened, interest rates could begin to rise modestly, which should help support lenders' margins.

US economic recovery has yet to really be reflected in loan growth, however. For instance, JPM saw its loan book rise just 0.6 per cent during 2013, while Bank of America's and Wells Fargo's grew by 2 per cent and 3 per cent, respectively. Although there's evidence that this still weak level of credit demand is focused on consumer lending. Citigroup's consumer book, for example, grew just 2 per cent in 2013, but its corporate loan book jumped 12 per cent. Moreover, smaller and more regionally based lenders may be doing better - Bank of New York Mellon (US: BK), for instance, saw its loan book grow by 11 per cent last year.

At investment banking operations, meanwhile, performances looked fairly mixed overall as weak revenues from fixed income and commodities trading were often offset by stronger results in activities such as equity trading. Regulatory developments won't help here, either. Take the Volker rule, which is designed to restrict US banks from making certain kinds of speculative investments that aren’t perceived to benefit customers. That's set to take effect from April and is likely to place some pressure on fee income at lenders' investment banking operations.

Capital prospects

But US banks are looking robustly capitalised. In fact, all of the major lenders appear compliant with Basel III minimum requirements, even though implementation for most isn’t until January 2015. Basel III requires lenders to hold core tier one capital (essentially equity) that's equivalent to 4.5 per cent of their risk-weighted assets, plus an additional 2.5 per cent buffer - giving a 7 per cent minimum ratio. The top five largest lenders (by assets), all reported end-December Basel III tier-one ratios of about 10 per cent. Compare that to expectations at RBS (RBS) for no higher than 8.5 per cent for end-2013.

With capital looking healthy, there's speculation that US banks could return funds to shareholders. Admittedly, they aren't generally great income plays and, from the top five US banks, only shares in JPM and Wells Fargo yield more than 2 per cent. But from those big lenders that do only pay fairly nominal dividends "share buybacks are likely", believes My Oja. Indeed, Bank of America announced plans to return $3.2bn in this way with its fourth quarter figures.

IC VIEW:

While misconduct fines and provisions look huge, such costs aren’t unexpected and the US banks look generally able to weather that storm. More significantly, the relatively healthier state of the US economic recovery offers better growth prospects for its lenders than in most other developed countries. Moreover, US banks are generally only modestly exposed to significant international risks - Bank of America's exposure to the weakest EU countries, for instance, is just $10.4bn. On that basis, and with shares still looking fairly modestly rated in many cases, investors could do worse than buy into those lenders heavily exposed the US recovery.

Favourites
Bank of America is our top pick. It's an excellent recovery play after being hit hard in the financial crisis and is relatively less exposed to investment banking - which leaves it a fairly direct play on the improving US economy. The bank is tough on costs, too. Reflecting that, earnings have bounced back fast and, while the dividend yield is unattractive, the bank plans to return capital through share buybacks. Yet the shares, trading below end-2014’s forecast book value, aren’t pricey by international bank standards. At $16.66, we reiterate our buy tip ($8.58, 13 September 2012).

Outsiders
JPMorgan Chase's fourth-quarter loan growth was among the weakest in the sector. It also seems to have been in the news more than its peers regarding fines and compensation - not ideal for sentiment. True, the dividend yield is the best of the top 10, but it’s still nothing special for its international peer group - HSBC's (HSBA) 2014 prospective yield, for example, is nearer 6 per cent. While the shares, rated on 1.1 times end-2013's book value, aren't overly cheap.

AMERICA'S TOP 10
BankMarket valueBasel III capital ratio†Prospective yield*Price/forecast book value*
Wells Fargo$242bn9.78%2.8%1.5
JP Morgan Chase$210bn9.5%2.6%†1.1†
Bank of America$179bn9.96%0.9%0.7
Citigroup$146bn10.5%1.0%0.7
Goldman Sachs$78bn9.8%1.3%1.1
US Bancorp$73bn8.8%2.5%1.9
Morgan Stanley$58bn10.5%0.8%0.9
PNC Financial$44bn9.4%2.4%1.1
Capital One$41bn10.9%2.3%1.5
Bank of New York Mellon$37bn10.6%2.1%1.0
*Based on JP Morgan's forecasts for end-2014
†Reported end-2013 figures

THE BROKERS' VIEW:

Steady, but not spectacular

On the face of it, recent fourth-quarter earnings releases from the US banks weren't so impressive. Indeed, S&P Capital IQ estimates that S&P 500 index bank members grew loans held for investment by just 2.3 per cent in 2013 - a slightly faster pace than in the preceding two years, but nothing special. According to FDIC (Federal Deposit Insurance Corporation) statistics, growth averaged 7.4 cent in the 15 years ended 2007.

With the economy slowly improving, however, US chief executives are more optimistic about loan growth and loan demand than they were a just few months ago. Fifth Third Bank's chairman Kevin Kabat thinks "sources of customer uncertainty related to the economy, budget battles etc have diminished and that makes us hopeful that 2014 will provide a stronger backdrop to economic activity and borrowing than 2013". S&P Capital IQ expects 2014 loan growth to accelerate to a 3.7 per cent clip, led by commercial mortgages and lines of credit.

But, even though loan growth is rising, banks' earnings won't necessarily soar in 2014. As credit quality improves, provision writebacks help support earnings growth. But that benefit diminishes with time. Underlying earnings at the big US lenders, which have generally been good rebound stories in recent years, will struggle to grow earnings fast. In fact, we anticipate that S&P 500 bank profits will grow at 13 per cent overall in 2014, compared to 23 per cent in 2013. A better earnings story for 2014 can possibly be found at the mid-tier banks - such as SunTrust Banks, BB&T Corp, Regions Financial Corp, and Comerica Inc. They've been hit less hard by legal and misconduct-related issues, but should benefit from rising short-term interest rates. Their shares do, however, tend to be more expensive, on future earnings, than the largest banks.

Erik Oja, US banks equity analyst at S&P Capital IQ