JP Morgan & Wells Fargo Set Tone, Though Margin Compression Looms on the Horizon

By George Gutowski - April 18, 2012 | Tickers: JPM, WFC | 0 Comments

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Everyone is applauding JP Morgan (NYSE: JPM) and Wells Fargo (NYSE: WFC) about their Q1 numbers. Red ink has turned black in many categories. Much improvement has been experienced in credit loss reserves. It's always nice when you stop losing money becuase your customers are now able to meet their obligations. Not exactly a genius certification but more of a fundamental must have category. So if you believe the economy is improving as both sets of executives maintain, you will see gradually improving fundamentals. Wells Fargo even went so far as to say that loans and mortgages taken on now in the early stages of the recovery have less risk than loans and mortgages taken on in the latter stages of the economic cycle [some would say bubble]. This is hard to argue so far.

But think in terms of game changers. Nothing ever proceeds in a straight line. Financial institutions live and die by their ability to maintain an adequate net spread. That is the difference between what funds cost and what they can charge their clients who can meet their obligations. Interest rates are at historically low levels. Yield oriented depositors and investors are only too aware of the pain and suffering low-interest rates have exacted.

The market dynamic in a rising interest environment will be for borrowers to attempt to lock in long while providers of funds in whatever form will attempt to stay short and lock in better rates higher up the cycle. This happens every time interest rates bottom and then start to rise. Also while the credit risk seems to be improving as loans and mortgages increase in cost, a lot of underwriting starts to fall apart. Most consumers will struggle with an extra three percent cost on their mortgage.

We may already be seeing the beginnings of margin compression. Concern has been raised about JP Morgan's increased cost of long-term debt which would be provided by bond investors who should be the smartest guys in the room when it comes to interest rates. Some may argue that even with short term margin compression, would not the increasing credit quality of the portfolio skate investors back on side? With reduced credit loss provisions and even large scale reversals of previous write-offs, investors will experience increasing black ink that more than compensates for compressed margins. This is true for a few quarters at most. Bank investors always view with suspicion the constant reversal of credit losses. Bank regulators would certainly go ballistic if they sensed management was manufacturing those circumstances.

The fundamental banking revenue model is to charge more interest than you have to pay. Add your fees, deduct your non interest expenses, and then pay your shareholders with net earnings after all items. Banks and financial institutions are supposed to know how to manage interest rate cycles. Investors will expect margins to remain robust. A decline in margins will not be tolerated in the market and share valuations will fall if bankers cannot come up with the goods. At this point, worries about interest rate margins are not priced into bank stocks. But I believe they will be soon.

So do not be lulled into a false sense of security with the two supposed better names in the banking sector. They will all experience the same challenges of margin compression. It happens with every increase in the interest rate cycle. So far management is whistling through the grave yard and not speaking about it.

Iceberg straight ahead!

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