In late June, the Fed said a prolonged economic downturn could saddle the nation’s biggest banks with billions in losses on soured loans and ordered them to cap dividends.
Photo: leah millis/ReutersBank earnings can sometimes be a snooze. But the stakes this quarter are unusually high.
Investors need to pay more attention than usual because their dividends are potentially at stake. New Federal Reserve rules will limit third-quarter payouts to the average level of profits a bank made over the prior four quarters. The first quarter of 2020 saw the beginning of impacts from the coronavirus crisis—and the second quarter will see more. Wells Fargo, which reports on Tuesday, has already said it expects to cut its payout. For some banks whose earnings are expected to be on the cusp according to analyst forecasts, such as Capital One Financial, second-quarter results could put pressure on payouts, particularly if the Fed extends its test into additional quarters.
The major factor for earnings will be banks’ credit provisions. As in the first quarter, banks are expected to add billions to their loan-loss reserves due to the economic effects of Covid-19 on borrowers. Even though actual defaults, among consumers and the investment-grade companies that borrow directly from banks, have been forestalled or curtailed by government stimulus and forbearance programs, under new accounting rules banks must project their credit losses far forward into the future.
One question mark, then, is how much banks believe those programs will ultimately reduce potential losses, rather than simply delay them. Banks’ commentary on what they are seeing underneath the headline trends will be closely scrutinized. However, even if banks see reasons for optimism, they have few incentives to under-reserve, especially considering that another, special Fed stress test looms later this year.
Working in banks’ favor this quarter will be investment banking. Citigroup and JPMorgan Chase, which also report Tuesday, have both guided toward trading revenue rising year-over-year by 40% or more. Fees earned on debt and equity underwriting also likely surged in the quarter.
Some bankers are warning that this bump might not extend into the second half—so investors aren’t likely to award these revenues with a very high multiple, given their somewhat temporary nature. But they should help banks with big Wall Street arms avoid questions about their ability to keep paying dividends, at least in the near term.
Meanwhile, earnings from lending and interest are under big pressure. On the plus side, thanks to a historic dash to cash by companies and individuals willing to park money in noninterest-bearing accounts, funding costs will be low. On the flip side, interest collected will suffer. For example, while banks stand to reap billions in fees on Paycheck Protection Program loans, much of that income will likely be spread over the life of the loans. Plus, those loans pay only 1% in actual interest, which won’t even materialize if many are forgiven.
It isn’t just about the margin earned on lending, either. Despite the surge in PPP loans, banks’ loan books might be shrinking. Sharply falling consumer-loan balances, notably via cards, and the end of a wave of corporate credit-line drawdowns put pressure on banks’ total interest income. Indeed, one consequence of a surge in capital-markets activity is that companies can pay down those bank loans.
Fed figures across U.S. banks tracked by Brian Foran at Autonomous Research show deposits still growing at an annualized pace of 17% over the prior month at the end of June. Loans, however, are shrinking at an annualized 19% pace over the past month. That isn’t a favorable formula for bankers.
Investors at least have their hopes contained. While consumer-discretionary stocks in the S&P 500 are up 31% in the past three months on hopes for a V-shaped recovery, S&P 500 financials are little changed over that time. Without some major surprises, this quarter is unlikely to convince investors that banks are also on the other side of this crisis.
Write to Telis Demos at telis.demos@wsj.com
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