How big banks earned so much money this quarter

We are a few weeks into earnings season and it should be abundantly clear that financial institutions are firing on all cylinders.  In fact, financials are leading the broader market for the first time since 1993.  Yet, loan losses have been absolutely enormous.  What gives?

The Great Giveaway is the essence of recent market performance in a nutshell.  Let’s look at U.S. Bancorp for a second as an illustration.  In March, Warren Buffett mentioned in some CNBC interviews that he felt the underlying earnings power of his major holdings in financial shares, Wells Fargo and U.S. Bancorp, was pretty robust.  Both have come out with some pretty bullish announcements since then.  U.S. Bancorp announced its earnings yesterday.  This is how Deal Book reported the event.

U.S. Bancorp, one of the 10 largest U.S. banks, reported higher-than-expected quarterly earnings on Tuesday on record revenue from mortgages, sending its shares up almost 21 percent, Reuters said.

The strong mortgage activity helped to offset losses from lease financing, construction and development loans, and credit cards.

The bank also put aside $1.3 billion for loan losses, $833 million more than a year earlier, as declining home prices affected both consumer and commercial loan portfolios. Chief Executive Richard Davis expects to set aside similar amounts in the next two quarters, before loan losses start to moderate toward year end.

“I don’t expect us to stop reserve-building until which time we see strength in the reduction of (losses),” he said on a call with analysts.

Shares soared on the results to finish up 20.9 percent at $19.27.

“Our credit costs are elevated like the rest of the industry but we were able to offset that with our core businesses,” Chief Financial Officer Andrew Cecere told Reuters in an interview.

The bank in November took over failed California lenders Downey Financial and PFF Bancorp, with support from the federal government.

“I would expect to see more of the same, but nothing large,” Mr. Cecere told Reuters, when asked about future acquisitions.

First-quarter profit for common stockholders fell to $419 million, or 24 cents per share, from $1.08 billion, or 62 cents per share, a year earlier.

Analysts on average were expecting the Minneapolis-based company to earn 20 cents a share.

Like Wells Fargo and JPMorgan Chase, which both reported last week, U.S. Bancorp saw record mortgage production revenues from new applications and refinancing.

But broader interest in loans started to decrease in the second half of the quarter, Mr. Davis said on the call, attributing this to customers becoming more careful.

“There are a number of customers who are neither as qualified as they were a year ago, nor are they interested in (more) debt,” he said.

U.S. Bancorp received $6.6 billion in taxpayer funds under the U.S. government’s Troubled Asset Relief Program last year, and TARP recipients have been under fire for not extending this money to customers.

“We have not denied a single credit-worthy customer since the beginning of this downturn,” Mr. Davis said. The bank hopes to repay the $6.6 billion once regulators approve, he said.

What you should have noticed is this:

1. There were massive loan losses at U.S. Bancorp (“The bank also put aside $1.3 billion for loan losses, $833 million more than a year earlier, as declining home prices affected both consumer and commercial loan portfolios. Chief Executive Richard Davis expects to set aside similar amounts in the next two quarters, before loan losses start to moderate toward year end.”)
2. So what.  U.S.  Bancorp made a lot of dosh anyway.  How? “Like Wells Fargo and JPMorgan Chase, which both reported last week, U.S. Bancorp saw record mortgage production revenues from new applications and refinancing.”
3. But, what’s more, they received $6.6 in bailout funds AND they got to pickup a few assets like Downey Financial’s carcass courtesy of the FDIC. (“The FDIC and U.S. Bank entered into a loss share transaction. U.S. Bank will assume the first $1.6 billion of losses on the asset pools covered under the loss share agreement, equal to the net asset position at close. The FDIC will then share in any further losses.”)
4. And, finally U.S. Bank is getting massively subsidized debt issuance courtesy of every big bank’s new friend, the former Grim Reaper FDIC (“Fitch Ratings has assigned ‘AAA/F1+’ ratings to debt issued by U.S. Bancorp (USB) through the FDIC Temporary Liquidity Guarantee Program (TLGP). Specifically, USB issued $750 billion of 2.25% senior notes due March 13, 2012.”)

So, what you are seeing at U.S. Bancorp are real profits coming courtesy of Federal Government largesse. Now, I happen to believe that U.S. Bank is one of the better big banks in the U.S. But for the sake of argument, let’s assume they were in dire straits and were on the verge of collapse pre-TARP.

That’s not a problem now.

Lots of revenue. The Fed has engineered low long-term interest rates by buying into the treasury and MBS market with money they created out of thin air. The result has been a lot of refinancing and new mortgage applications. Check.

Lower liquidity constraints and unimpaired assets. The FDIC has given U.S. Bank the deposits of Downey after it was bankrupted, much as Wells Fargo got Wachovia and JPMorgan got Washington Mutual. These deals were done on extremely favourable terms because many of the losses will have been recorded before the takeovers. Therefore, U.S. Bank, Wells and JPM are getting huge deposit bases and a large asset book without most of the losses the legacy organizations would have carried in a merger. That means they all get low-cost funding not subject to rollover risk (the wholesale market which bankrupted Northern Rock) and relatively unimpaired assets. Check.

Capital injection. U.S. Bank also got a big fat check for $6.6 billion under the TARP. This should go a long way toward helping recapitalize the bank and insuring it as a safe counterparty and depositary institution. Check.

Low-cost funding. Finally, U.S. Bank is getting FDIC-subsidized funding. It’s kind of like the kind of sweet deal Fannie and Freddie have gotten in that investors felt agency debt was implicitly backed by the Federal Government.

The long and short, there fore is that U.S. Bank is getting a huge helping hand from the government. Even if it had been impaired beforehand, it would look much better now. The fact that their earnings STILL fell some 60 percent, gives you an insight into the magnitude of the problem i.e. loan losses.

The conclusion I have drawn from this is that the big banks will be earning a lot more money than had been anticipated before Q1 results were released. Nevertheless, continued problems in the prime mortgage and commercial real estate markets will be a drag on earnings as indicated by the huge writedowns at U.S. Bank and other banks like BofA. You should also note that credit card delinquencies are equally problematic. The regionals, with their construction loans and CRE exposure, are going to be taking it on the chin here.

Until and If these headwinds become insurmountable, big banks will be making money. Regional banks and local banks, not so much.

Sources
U.S. Bancorp Posts Higher-Than-Expected Profit – Deal Book
Fitch Rates U.S. Bancorp’s FDIC Guaranteed Debt ‘AAA/F1+’ – Market Watch