Avoid Financials: Bank Earnings Are Set to Slide

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Flat or falling revenue will plague major bank earnings as second-quarter results are reported this week – delivering yet another blow to battered financial stocks.

Most of the big banks are expected to report a profit, but a falloff in equity trading volume, weak demand for loans, and costly legal headaches all ate into revenue, which will be a prime concern for already-skeptical investors.

All of the big bank stocks are down since the beginning of the year, several more than 20%.

"To say the least, it has been a challenging quarter for the universal banks, as concerns over a disappointing spring housing market, slowdown in the global economy and concerns over counterparty risk to European banks have all worked in concert to cause underperformance," Keefe, Bruyette & Woods analysts wrote in a note to clients.

JPMorgan Chase & Co. (NYSE: JPM) kicks off two weeks of big bank earnings later today (Thursday) followed by Citigroup Inc. (NYSE: C) tomorrow (Friday). Wells Fargo & Co. (NYSE: WFC), Bank of America Corp. (NYSE: BAC) and Goldman Sachs Group Inc. (NYSE: GS) are all slated to report Tuesday, with Morgan Stanley (NYSE: MS) expected next Thursday.

Analysts are expecting an average drop in big bank revenue of between 6% and 8%.


Trading Falls Off

The biggest culprit may be the decline in equity trading revenue, which dropped 4.4% from last year and 17% from the previous quarter. Although those percentages aren't huge, trading accounts for about a quarter of most major banks' revenue – and almost 79% of Goldman Sachs' business.

Average daily trading volume on the U.S. exchanges fell 31% from the previous quarter to its lowest level since the end of 2007. Investors pulled back over concern about the sputtering U.S. economy, the inconclusive battles over the debt ceiling and budget deficit, and the escalating European debt crisis.

Worse still, major investors were even more reluctant to indulge in riskier – and for the banks, more lucrative – products like complex options and derivatives.

"Client risk appetite has declined, risky asset prices are lower and client activity levels are considerably weaker," Howard Chen, an analyst at Credit Suisse Group AG (NYSE ADR: CS), told The Telegraph.

Implementation of the Dodd-Frank regulations, which has reduced income from customer fees, also took a bite out of revenue. And the banks stand to lose even more fee revenue when the amount they can charge retailers for credit card transactions gets cut by more than 40% later this year.

Bank earnings

The banks' loan business also continues to struggle. According to Federal Reserve data, residential loans were down 2% in the quarter from a year ago, while commercial loans were down 8%.

And prices for mortgage-backed securities plunged when the Federal Reserve Bank of New York started to unload some of the bad mortgage bonds it acquired from American International Group Inc. (NYSE: AIG).

Legal Troubles

In addition to haunting the banks' loan portfolios, the legacy of the subprime mortgage crisis resulted in a several costly lawsuits this past quarter.

In the largest bank settlement ever, Bank of America agreed to pay $8.5 billion to investors who lost money on sour mortgage-backed securities. The bank has already warned that the one-time charge of $14 billion will result in a quarterly loss of between $8.6 billion and $9.1 billion.

Wells Fargo agreed to pay a group of pension funds and other investors $125 million to settle a suit that alleged the banks failed to warn them of the risks related to mortgage-backed securities.

JPMorgan Chase agreed to pay the Securities & Exchange Commission (SEC) $154 million over similar allegations that it had failed to properly disclose the risks of mortgage-backed securities; the bank also settled for $211 million in a case in which it was charged with rigging bids to win government business.

With so many problems weighing down bank earnings, some analysts suspect some may release a portion of their loan-loss reserves to make the numbers appear a bit less dreary.

Last quarter the release of loan-loss reserves accounted for half of JPMorgan Chase's $5.56 billion profit. Citigroup used $3.37 billion in reserves to avoid reporting a loss.

About the only bright spot in the big bank earnings reports will be in mergers and acquisitions.

JPMorgan Chase should see a 28% gain from its investment banking unit; both Goldman Sachs and Morgan Stanley are expected to see some benefit from bringing such social media companies as Linkedin Corp. (NYSE: LNKD) and Pandora Media Inc. (Nasdaq: P) to market.

But the gloomy bank earnings already have several firms looking to cut costs. Goldman Sachs already has announced it will eliminate 230 jobs in New York by this fall. Morgan Stanley has announced intentions to cut $1 billion in non-compensation expenses over three years, and intends to shed some brokers as well.

"If you're a short-term investor, banks are going to struggle, probably for the next six to 12 months," Michael Yoshikami, chief executive officer and founder of YCMNet Advisors, told Bloomberg News.

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