(By Mani) Second quarter earnings are set to kick off on July 9, and the large cap commercial bank space is positioned for continued improvement in earnings.
The banking sector is experiencing improvements in asset quality and loan demand, while credit spreads have been widening and underwriting and trading volumes have weakened.
The wild card remains the ongoing European financial crisis, which is clearly driving another "risk off" quarter accompanied by trading inactivity and pressure on investment banks' trading revenues, and that market skittishness is in turn leading to a relative absence of new M&A activity and relatively weak underwriting activity.
Meanwhile, economic indicators point to continued positive loan growth in commercial & industrial (C&I) loans, residential mortgage, and other consumer loans.
'We are above consensus for three out of six of our large cap banks (STI,USB, WFC), mainly in-line with BBT and RF, and below consensus on PNC," UBS analyst Greg Ketron said in a client note.
For the quarter, the analyst sees EPS increasing 6 percent from the first quarter and 32 percent from last year, driven by growth in net interest income, higher mortgage revenues, cost control and benefits from acquisitions several banks have made using cash to maximize accretion.
Meanwhile, SunTrust Banks, Inc. (NYSE:STI), US Bancorp (NYSE:USB) and Wells Fargo & Co. (NYSE:WFC) are expected to see the greatest upside in the earnings this quarter.
"We continue to believe that USB is the best stock to own in the current environment and note that we see further upside in the stock along with our Buy-rated BBT and STI," Ketron added.
Meanwhile, loan growth has picked up momentum in the second quarter compared to the first quarter and SunTrust is best positioned in terms of exposure to high-growth loan categories with above average exposure to the top three growth categories, including C&I. Other banks that are well-positioned are US Bancorp and Wells Fargo.
In addition, banks have supported the net interest margin by reducing dependency on wholesale funding and relying more heavily on low-cost deposits. Loan to deposit ratios were high coming into the cycle, and the positive from deleveraging was that the group had pricing discretion and type of funding discretion over the last four years.
Net interest margins have been steadily declining since the second quarter of 2010. The benefit of down-pricing or running off higher-rate funding is slowing, while companies still have higher-rate loans and securities cash-flowing which are replaced with lower- yielding assets.
"Though the NIM has contracted steadily over this period, the banks have benefited from loan growth, particularly in C&I and to a lesser degree in residential mortgage and consumer loans," Ketron added.
This, coupled with liability restructuring, the favorable deposit mix shift towards lower-cost deposits, and down-pricing deposits, supported net interest income for the group over the period, which increased consistently through 2011.
On the positive side, mortgage banking should have another good quarter. According to the Mortgage Bankers Association (MBA) mortgage forecasts, mortgage originations are projected to increase by 10 percent.
Mortgage originators continue to benefit from the low rate environment and government sponsored programs, with HARP 2.0 being a significant contributor, contributing as much as 30% to mortgage refinancing levels. Due to the positive pricing trends and origination forecasts, mortgage revenues will be elevated in the second quarter.
"We think WFC and STI will have the largest benefit due to their greater dependency on mortgage revenues as a function of total revenues and note that USB has been growing market share in the mortgage business," Ketron noted.
Among the key banks, investors should watch Citigroup, Inc.'s (NYSE:C) progress of the wind-down of Citi Holdings and the speed at which the company can start chewing through its deferred tax asset.
With the level of net charge-offs probably down by over $1.5 billion on a year-over-year basis, the combination of normalizing trading revenues and diminishing losses should start generating some US taxable income.
For Bank of America Corp. (NYSE:BAC), trading has generally been weaker than expected, negatively impacting trading revenues. In addition, "hedge ineffectiveness" is once again an issue because long rates have declined sharply, and so the bank's net interest income would be reduced.
The results will in any case be messy for Capital One Financial Corp. (NYSE:COF) and difficult to interpret because this quarter will include the HSBC acquisition and a full quarter of the ING Direct acquisitions.
For JPMorgan Chase & Co. (NYSE:JPM), all eyes will be on the Chief Investment Office (CIO) trading. The company has made good progress in winding down its CIO positions and losses should be manageable, and it could be that the vast majority of the CIO losses will be taken in the second quarter.
For Wells Fargo, the one wild card remains mortgage banking revenues where investors should see good gain-on-sale margins and solid MBA purchase/refinance activity.
Goldman Sachs Group, Inc, (NYSE:GS) should be the most impacted in the current scenario as majority of their business lines were impacted by the weak trading environment in the quarter. In addition, since they have substantial investments in debt and equity from the precrisis, pre-Volker days, there are likely to be markdowns on these.