By and large, the major US banks have enjoyed a good quarter. All managed to beat expectations while, as expected, Bank of America and Citigroup were the only banks to make a pre-tax loss. The key themes were strong investment banking results, while credit costs remained high.

That investment banks – and universal banks’ investment banking divisions – should have prospered in a quarter when share and commodity prices rose and credit spreads tightened is no surprise. However, the scale of the recovery appears to have taken investors by surprise. This is best illustrated by the extent to which Goldman Sachs and Morgan Stanley, the US’ last remaining investment banks, outperformed consensus expectations. Goldman Sachs’ Q309 earnings per share (EPS) came in at $5.25, 26% more than expected. And Morgan Stanley’s EPS of $0.38 topped expectations by 27%. Meanwhile, JPMorgan’s investment banking division’s net income rose 118% YoY to $1.9bn, while non-interest income increased 83% YoY at Bank of America and Citigroup’s non-interest revenue rose threefold YoY. Clearly US banks’ outperformance rests heavily on recent strength in financial markets. But this will not last for ever.

Chart 1: US investment banks’ pre-tax income

Source: Company data

While favourable market movements have allowed investment banks to prosper, universal banks’ profits have been held back by credit losses (see chart below). Typically, credit losses increased by 1.5-2x between Q308 and Q309, with the majority of losses coming from credit-card and mortgage loans. But there are hopes that loan losses may be approaching their peak. Wells Fargo commented that it expected loan losses to peak in 2010, while Bank of America saw them reaching their zenith in Q409. And several banks reported credit losses in Q309 that were lower than those suffered in the previous quarter. But perhaps most revealing was Citigroup’s decision to add just $802mn to reserves in Q309, compared to around $4bn in Q308. It clearly now feels that it has a buffer strong enough to absorb future losses. Finally, the negative effects of the loan losses have been partially offset by falling writedowns. In Q308, for example, Citigroup suffered writedowns of around $12bn, according to Bloomberg data. In Q309, the equivalent figure was “only” $1.7bn. And JPMorgan even wrote back $400mn on its leveraged loans and mortgage-related positions; in Q308, it wrote down $3.6bn.

Chart 2: US banks’ loan losses

Source: Company data.   *Wells Fargo and Bank of America’s Q309 credit losses have been increased by
their respective takeovers of  Wachovia and Merrill Lynch in Q408.

US banks may therefore begin to bring their balance sheets under control again within the next year. In this respect, one more point should be made. While most banks now appear well capitalised, a few stood out as having less in reserve than their peers. This particularly applies to common Tier 1 capital, which promises to be regulatory bodies’ and investors’ new focus. Wells Fargo, for instance, ended Q309 with a common Tier 1 capital ratio of just 5.2%, while Bank of America posted 7.3%. The rest of the major banks – other than Morgan Stanley (8.2%) – had common Tier 1 ratios exceeding 9%. We would therefore not be surprised if Wells Fargo and/or Bank of America were to look to raise a significant amount of fresh capital in the coming quarters.

Nicholas Smallwood, Credit Analyst

Disclaimer:

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Nicholas Smallwood, Credit Research
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