subman
Year after year, whenever economic storm clouds appear over the horizon, bank stocks seem to react as though every tempest is a category 5 hurricane. Precious little credit is given to the vastly different regulatory and capital framework that has existed since the Global Financial Crisis, where the banks now hold double the capital and liquidity. Recession concerns and a rampant inflationary environment have pressured bank stocks, including the leader of the pack JPMorgan (NYSE:JPM). This selloff has created an opportunity to own this best-in-class and immensely profitable banking franchise at an extremely compelling price.
Often bank stocks are criticized as being almost like utilities due to the more conservative regulatory framework. Many see this as a slander, but I think of it as a compliment, as most bank stocks would be worth 50-100% more if given a similar valuation to utilities. We’ve seen time and again that the big banks can make money in a low interest environment, in a weak capital markets quarter, or even when they had to aggressively ramp up credit provisioning to deal with the huge growth in unemployment as a result of the 2020 lockdowns.
The analyst industry might be even worse than the average market participant, regularly focusing on one myopic issue at a time, instead of seeing the forest through the trees. These are businesses with a variety of diverse revenue streams, varying from recurring and stable businesses to lucrative but cyclical ones. Importantly, the businesses complement each other well so that when one business is struggling, others can pick up the slack keeping the enterprise profitable in all but the direst scenarios. When you look at where you can get the most net income that is reliable and likely to grow at a modest rate, for the cheapest price, I believe banks on average are the most attractive opportunity in today’s stock market.
When the Federal Reserve began the stress testing process in 2009, I thought it was a good idea to ensure confidence in our financial institutions. Then the new regulatory framework made banks much safer with the enhanced capital and liquidity. Now each year, the Fed conducts more and more unrealistic stress tests where just about every aspect of financial markets and the economy breaks down, and then has banks retain capital requirements to meet their models. This results in way too much change and nonsensical adjustments to business models, just to meet these hypothetical models that aren’t in the best interests of the economy, consumers, or our capital markets.
For instance, it makes absolutely no sense for a large bank like JPM to keep mortgages on the balance sheet due to the amount of capital required to hold them, versus the lower yields and risks that come with them. The U.S. mortgage market is not the swashbuckling securitization casino that it was prior to the Financial Crisis and these policies become counterproductive. Jamie Dimon is never one to mince words and here were his comments on the stress test.
“The stress loss doesn’t even remotely represent what would happen under that kind of scenario. I would tell you; we’d make money under that scenario. We wouldn’t lose. I think they had us losing $44B. There’s almost no chance that would be true. I feel bad for shareholders because they look at that and say, well, what’s going to happen and there’s good evidence. We didn’t lose money after Lehman. We didn’t lose money in the Great Recession. The Company has got huge underlying earnings power and consistent revenues in CCB, Asset Management, Custody, Payment Services. And then, we have some fairly volatile streams. Now, we’ve got the CECL, which obviously can go up or down quite a bit, but again, that’s an accounting entry. And so, we feel in very good shape. We just have to hold a higher number now, and we’re going to get there.”
JPM and the other big banks have been stress tested in the real world, including in 2020 with the Covid-19 lockdowns, where unemployment rocketed to 15% within three months. The company added $15B to reserves in two quarters without creating any problems in that utterly dire scenario. It’s ridiculous to keep making drastic changes to the capital requirements of the large banking institutions based on hypothetical models conducted by academics. They’ve already doubled the capital and liquidity since the Financial Crisis, so at some point it would be nice to have a bit of consistency and set rulebook. To point to the countercyclicality of JPM’s various businesses, even in a scenario where they had to add $15B to reserves again, which I think is highly unlikely, management forecasts that NII will be on a $10B higher annual run-rate by the end of the year due to higher interest rates.
On July 14th, JPM reported 2Q net income of $8.6B and earnings per share of $2.76, off $31.6B of managed revenue. JPM’s ROTCE for the quarter was an annualized 17%, which is pretty unbelievable when you consider how weak the non-trading Investment Banking results were. Few businesses can produce these types of ROTCE numbers on the massive amounts of capital invested into the operation like JPM has. Expenses of $18.7B were up $1.1B or 6% YoY, mostly due to higher investments and structural expenses. Average loans of $1.1T were up 7% YoY and 2% QoQ. Average deposits of $2.5T were up 9% YoY and up 1% QoQ. CET1 capital stood at $207B, with a Standardized CET1 capital ratio of 12.2%, and an Advanced CET1 ratio of 12.8%. The company paid a common dividend of $3.0B, or $1.00 per share in the quarter, along with $224MM of common stock net repurchases. Management mentioned that they are pausing their stock buyback program for the short-term, as it needs to raise capital to meet new higher requirements, which I wouldn’t expect to take longer than two quarters or so, as the bank pushes its Standardized CET1 upwards of 12.5% by next year.
The CCB generated $3.1B of net income on revenue of $12.6B, which was down 1% YoY. In Consumer and Business Banking, revenues were up 9% YoY, due to growth in deposits, which were up 13% YoY, and 2% sequentially. Client investment assets were down 7% YoY, due to weaker market performance, partially offset by inflows. Home lending revenue was down 26% YoY due to higher rates. Mortgage origination volume of $22B was down 45% YoY. In Card & Auto, revenue was down 6% YoY, due to higher acquisition costs and lower auto lease income, mostly offset by higher Card NII. Card outstanding were up 16% and revolving balances were up 9%. Auto originations of $7B were down 44% YoY from record levels, due to low vehicle supply. Credit performance remained quite strong with credits costs of $761MM, reflecting net charge-offs of $611MM, down $121MM YoY, driven by card and $150M in card-driven loan growth.
The CIB generated $3.7B of net income on $11.9B of revenue. There were $370MM of net markdowns on equity investments, with about $345MM of that reflected in payments, and markdowns on the bridge loan book of approximately $250MM in IB revenue. These numbers aren’t that worrisome when you think of the size of the drawdown in both equities and fixed income, and the size of JPM’s portfolio. Investment Banking revenue was down 61% YoY to $1.4B, with IB fees down 54% versus a record in 2021. JPM’s wallet share maintained its leading position at 8.1%. Advisory fees were down 28%, due to extremely weak capital markets activity in the quarter. Underwriting fees were down 53% for debt and 77% for equity. Capital markets are likely to remain challenging in the near future, but the backlog should continue to build for when things loosen up. In Markets, total revenue was up 15% to $7.8B, as volatility presented lots of opportunities. Security Services revenue was up 6% YoY to $1.2B, due to higher fees and rates. Commercial Banking produced net income of $1B on revenue of $2.7B, which was up 8% YoY. Loans were up 4% sequentially, with C&I loans up 6%, due to higher revolver utilization and originations across Middle Market and Corporate Client Banking. Asset & Wealth Management reported net income of $1B with a pretax margin of 31%, on revenue of $4.3B, which was up 5% YoY.
Management raised its expectation of NII ex markets from $56B to $58B due to interest rate increases, while adjusted expenses should still be around $77B. By the end of the 4th quarter, management believes that NII should be on an annualized pace of generating $68B per annum. This really speaks to the diverse revenue streams that JPM has in that capital markets might be weaker, but they benefit hugely from higher interest rates in net interest income. Same thing with their Trading Markets businesses, which benefit from the volatility. These revenues can help substantially offset any incremental damage to credit that may come as the year progresses. CECL accounting requires banks to reserve for the life of the loans, so it is an inherently conservative accounting framework, and JPM adjusted its negative scenarios in the 1st quarter, so it really didn’t have to make major changes this quarter.
To give an idea of how good credit still is, despite all the turmoil and inflation, Card net charge-off is still expected to be less than 2% for 2022, making this very different than previous recessions. Jamie Dimon said “the consumer right now is in great shape. So, even if we go into a recession, they’re entering that recession with less leverage and in far better shape that they’ve been in 08 and 09, and far better shape than even they did in 2020.” Commercial credit is even better and Dimon said “we’ve never seen business credit better ever, like in our lifetimes, and that’s the current environment.” Loan growth is expected to be mid to high single-digits for the year, led by C&I growth and higher revolver utilization. Credit cards also have substantial upside potential as consumers carry higher balances, as opposed to paying them off each month as they had been doing with their surplus savings.
The economy is not reflective of a recession, although I’m in the camp personally that we are likely to be in a technical one sooner than later. Combined debit and credit spend is up 15% YoY. The average consumer is spending 35% more YoY on gas and roughly 6% more on recurring bills and other nondiscretionary categories. Travel and dining spending has grown by 34% YoY. Spending has certainly grown faster than incomes, which means that median deposit balances are down across income segments for the first time since the Covid-19 pandemic started, but cash buffers are still higher than normal.
At a recent price of $108, JPM trades at 8.6x forward earnings, and 8x trailing earnings. This is ridiculous for a best of breed bank, posting high teens return on tangible capital equity numbers, that will still be very profitable in a pretty substantial recession. JPM has a tangible book value per share of $69.53, which was basically flat sequentially due to the continued pressure on AOCI from higher rates. The market capitalization is around $317B for a business that produced $48B of net income last year, and just under $30B during 2020, despite all the credit provisioning that was needed with unemployment at 15%. The dividend yield is a healthy 3.7% and while it is unfortunate that the company has to pause buybacks, they will resume before you know it as the company generates capital organically. I think the stock is about 25-35% undervalued, which is less of a spread than some of its peers, but there is also less uncertainty into the earnings profile in my estimation. I believe JPM is a good buy at current prices even with a recession looming.
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