Major U.S. Banks Continue to Hide Asset Deterioration

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Citigroup (NYSE: C) reported the results of its latest quarter ending September, with profits dropping by 87% from the same quarter last year to $468 million as it reduced the value of its joint venture in Morgan Stanley Smith Barney by $4.7 billion. Excluding the one-off expenses, Citi’s income rose to $3.3 billion. The bank is planning to sell its 49% stake in the firm back to Morgan Stanley (NYSE: MS). Still, the net income managed to beat analysts’ expectation, which is why the shares climbed 5.5%. The very next day, the bank again attracted global headlines when its famed chief executive Vikram Pandit resigned after serving for four and a half years. Mr. Pandit was then replaced by Citi’s Europe, Middle East, and Africa chief Michael Corbat.

Meanwhile, Morgan Stanley also reported its recent quarterly results, posting a massive $1 billion loss as it changed the valuation of its debt, which saw it reporting a drop from a profit of $2.2 billion from the same quarter last year. In the meantime Citi’s peers, JP Morgan (NYSE: JPM) and Wells Fargo (NYSE: WFC), have both reported record breaking results for the third quarter, with profits surging 34% to $5.7 billion and 22% to $4.94 billion, respectively. Bank of America (NYSE: BAC) has also managed to squeeze in a $340 million profit, despite the $2.4 billion settlement it reached with its shareholders over the acquisition of Merrill Lynch.  The company's profits are down from $6.2 billion in the same quarter last year.

The zero interest rate policy of the Federal Reserve does not seem to be hurting the headline earnings, as most of them have beaten the analyst’s expectations while their stocks continue to outperform the S&P 500. However, some, if not all, of this improved performance can be attributed to window dressing. In JPM’s case, the balance sheet reveals that $0.14 of its total EPS of $1.40 has come from the $900 million reduction in loan loss reserves. Similarly, Citi’s much hyped $1.06 EPS does not include CVA/DVA, MSSB’s loss ($4.7 billion pre-tax/$2.9 billion after tax), and $582 million tax benefit.  $1.06 is therefore meaningless; the actual EPS is $0.15.

Moreover, as mentioned above, Citi has also highlighted that excluding the one-off items its income climbs to $3.3 billion, which is “27% higher than the third quarter 2011.” However, this also includes the $1.5 billion reduction from their loan loss reserves, indicating that earnings are up at the expense of the firm’s assets.  When reading a U.S. bank’s earnings statement, it feels more like a game of three-card Monty than it does financial analysis.

Since January, the SPDR S&P 500 ETF (NYSE: SPY) has been up 14.2%, and its nearest performer has been Morgan Stanley, which is ahead with a 16.2% increase. Wells Fargo and JP Morgan have been up by 24.9% and 25.7%, respectively; meanwhile Citi and Bank of Ameria are in the league of their own, both surging by 42% and 71.7%, respectively, since January.

Their profit margins reveal a different story. Only WFC and JPM have been able to improve their margins, although how much of it is attributed to operational performance is another story.   Financials were beaten hard in 2011 and some of these rises can be attributed to their results not being as bad as the market originally had feared. 

<table> <tbody> <tr> <td colspan="2"> <p><strong>Profit Margin (%)</strong></p> </td> <td> <p><strong>Sep-11</strong></p> </td> <td> <p><strong>Dec-11</strong></p> </td> <td> <p><strong>Mar-12</strong></p> </td> <td> <p><strong>Jun-12</strong></p> </td> <td> <p><strong>Sep-12</strong></p> </td> </tr> <tr> <td> <p><strong>C</strong></p> </td> <td colspan="2"> <p>14.03%</p> </td> <td> <p>4.17%</p> </td> <td> <p>11.72%</p> </td> <td> <p>12.23%</p> </td> <td> <p>2.47%</p> </td> </tr> <tr> <td colspan="2"> <p><strong>BAC</strong></p> </td> <td> <p>21.80%</p> </td> <td> <p>7.97%</p> </td> <td> <p>2.92%</p> </td> <td> <p>11.20%</p> </td> <td> <p>1.66%</p> </td> </tr> <tr> <td colspan="2"> <p><strong>JPM</strong></p> </td> <td> <p>17.93%</p> </td> <td> <p>17.36%</p> </td> <td> <p>18.90%</p> </td> <td> <p>22.36%</p> </td> <td> <p>22.70%</p> </td> </tr> <tr> <td colspan="2"> <p><strong>WFC</strong></p> </td> <td> <p>20.66%</p> </td> <td> <p>19.93%</p> </td> <td> <p>19.63%</p> </td> <td> <p>21.71%</p> </td> <td> <p>23.27%</p> </td> </tr> <tr> <td colspan="2"> <p><strong>MS</strong></p> </td> <td> <p>19.12%</p> </td> <td> <p>-3.50%</p> </td> <td> <p>-1.10%</p> </td> <td> <p>7.00%</p> </td> <td> <p>-14.98%</p> </td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> </tbody> </table>

Citi and BAC have clearly been underperformers, with profits falling from 14% & 21.8% in Sep-2011 to the current 2.5% and 1.7%; but their executives have been able to push the share prices up to extraordinary levels.

<table> <tbody> <tr> <td> <p><strong>Bank</strong></p> </td> <td> <p><strong>EV</strong></p> </td> <td> <p><strong>P/E</strong></p> </td> <td> <p><strong>Beta</strong></p> </td> <td> <p><strong>Yield</strong></p> </td> <td> <p><strong>ROA</strong></p> </td> <td> <p><strong>ROE</strong></p> </td> <td> </td> </tr> <tr> <td> <p><strong>C</strong></p> </td> <td> <p>($20.64)</p> </td> <td> <p>15.9</p> </td> <td> <p>1.91</p> </td> <td> <p>0.10%</p> </td> <td> <p>0.39%</p> </td> <td> <p>4.11%</p> </td> <td> </td> </tr> <tr> <td> <p><strong>BAC</strong></p> </td> <td> <p>$129.07</p> </td> <td> <p>25.81</p> </td> <td> <p>1.86</p> </td> <td> <p>0.40%</p> </td> <td> <p>0.25%</p> </td> <td> <p>2.32%</p> </td> <td> </td> </tr> <tr> <td> <p><strong>JPM</strong></p> </td> <td> <p>($19.18)</p> </td> <td> <p>8.93</p> </td> <td> <p>1.64</p> </td> <td> <p>2.80%</p> </td> <td> <p>0.84%</p> </td> <td> <p>10.12%</p> </td> <td> </td> </tr> <tr> <td> <p><strong>WFC</strong></p> </td> <td> <p>$186.83</p> </td> <td> <p>10.85</p> </td> <td> <p>1.13</p> </td> <td> <p>2.60%</p> </td> <td> <p>1.36%</p> </td> <td> <p>12.36%</p> </td> <td> </td> </tr> <tr> <td> <p><strong>MS</strong></p> </td> <td> <p>($180.10)</p> </td> <td> <p>N/A</p> </td> <td> <p>2.08</p> </td> <td> <p>1.10%</p> </td> <td> <p>N/A</p> </td> <td> <p>N/A</p> </td> <td> </td> </tr> </tbody> </table>

Wells Fargo has so far reported the highest return on asset and equity, and has the highest enterprise value as compared to its peers. Moreover, it has the lowest beta of the lot, meaning its stock has historically been less volatile, although anything bigger than ‘1’ results in either great rewards or significant losses in the stock value. Both WFC and JPM have relatively lower P/E as compared to C or BAC, coupled with much better yield and returns that makes them much more attractive.

In the current scenario, when the zero interest rate policy will persist for the next three years, it is difficult to imagine a scenario where banks will be able to improve and maintain their profit margins without the support of the central bank allowing them to continue to use their trading desks as their main source of revenue. 

Traditional banking fees are not covering expenses in this financially repressed environment.  And while it is politically important for the banks to project an air of invulnerability, lest there is a systemic loss of confidence, as investments they are dangerous beasts to try and ride.  At this point they are better trading vehicles than investments, as the financial sector of the economy is insolvent but still immensely powerful.

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PeterPham8 has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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