Credit worries overshadow likely strength in big US bank Q2 earnings

Second-quarter bank earnings reports kicking off this week are likely to be supported by blistering loan growth and sharply higher interest rates, but investors will be focused on signals about how an economic downturn could rock the industry.

"The near-term setup for the second quarter is generally quite strong," said Piper Sandler analyst R. Scott Siefers, with a "powerful updraft" in net interest income offsetting fee income headwinds from slumping investment banking and mortgage activity, and lower market values that determine compensation for wealth and asset management services.

But "the further out we go, the murkier the outlook becomes," Siefers added, pointing to skepticism about the sustainability of the loan growth and diminishing returns from further rate hikes by the Federal Reserve. "The bigger issue is, are we going to tighten ourselves into a recession or some sort of a credit event," Siefers said.

Overall, consensus analyst forecasts anticipate year-over-year and sequential revenue growth at the vast majority of the 17 publicly traded U.S. banks with more than $100 billion of assets. Consensus estimates expect just four to post growth in EPS relative to the year prior, however, when banks were still reporting large negative credit provisions as they unwound early-pandemic allowance builds.

Turn in provisioning

There have been few tangible signs of credit stress so far — a reading on delinquent credit card payments hit a new low recently, for example — and consensus estimates expect net charge-off rates to remain low at a median 20 basis points for the big bank group. The forecasts predict sequentially higher provisions at 14 of the banks, however.

"If you look at reserves to loans, in many cases, they're kind of back to a Day 1 CECL level," said Moody's Senior Vice President Allen Tischler, referring to banks' allowances after the adoption of the current expected credit loss accounting standard but before the pandemic came into focus. Tischler noted that JPMorgan Chase & Co. built reserves in the first quarter largely because of a higher probability of a recession and said, "You'd have to think that this quarter there will be more reserve builds."

Siefers noted that unemployment, which remains low, is a major input in banks' provisioning methodologies. Still, he said, "The one thing we can say with a fairly high confidence is that the days of reserve releases are swiftly coming to an end."

Weekly data from the Federal Reserve shows that aggregate loan loss allowances at U.S. commercial banks fell 2.3% to $157.35 billion from March 30 through June 29, and that the allowance to loans ratio fell from 1.46% to 1.38% over the same time.

NIM rebound

Analysts expect that strong loan growth and another 125 basis points of Fed hikes during the second quarter will help drive up revenue at the big banks.

Consensus estimates forecast year-over-year and sequential net interest margin expansion at almost all of them, including a sequential 35-basis point increase to 3.00% at M&T Bank Corp., which is getting a lift from the completion of its acquisition of People's United Financial Inc. at the beginning of April. The median projected sequential increase for the group is 13 basis points.

"Margins should just expand very rapidly and powerfully given how quickly the Fed has moved," Siefers said. "We've probably blown through loan [interest rate] floors very quickly."

* Download a tear sheet to run a stress test on banks and thrifts. * Download a template to generate a bank's regulatory profile. * Download a template to compare a bank's financials to industry aggregate totals.

Banks including Citigroup Inc. have projected sharp declines in investment banking earnings as securities issuance volumes have cratered, but that strong trading revenue has continued to be supported by heavy volatility.

The turbulence is also likely to hit leveraged loan operations as banks get stuck holding inventory that has been devalued by a rapid widening in credit spreads. Bank of America Corp. CFO Alastair Borthwick projected in June that the bank would absorb $100 million to $150 million of leveraged finance writedowns.

"There's going to be some pain in the quarter," Piper Sandler analyst Jeff Harte said. Still, "we're talking hundreds of millions of dollars, which while painful, isn't catastrophic."

It's the outlook

With investor sentiment weak, judging from bank stock performance this year, attention will be concentrated on "looking out the windshield," Harte said. "It's going to be a lot about the outlook and not so much about the actual numbers."

Banks have probably sold off too hard against an outlook for a mild recession in 2023 and credit losses deteriorating to levels about 10% higher than in 2018 and 2019, Harte said. But "the risk is if a mild recession turns into a significant recession. ...Then all of a sudden, you're probably looking at loss content that's going to be double or more what it was in 2018, 2019."

"If things do get horrible economically, these stocks are going to get hit hard," Harte said. There is a modest upside from a soft landing, "but if I'm wrong, the downside is probably a lot bigger."