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Q4 2012 Bank Earnings: Whither Net Charge Offs?
January 22, 2013

Q4 2012 Bank Earnings: Whither Net Charge Offs?

"24. In 1760 England, the chief slave-trading nation, was sending on an average to Africa 163 ships annually, with a tonnage of 18,000 tons, carrying exports to the value of �163,818. Only about twenty of these ships regularly returned to England. Most of them carried slaves to the West Indies, and returned laden with sugar and other products. Thus may be formed some idea of the size and importance of the slave-trade at that time, although for a complete view we must add to this the trade under the French, Portuguese, Dutch, and Americans. The trade fell off somewhat toward 1770, but was flourishing again when the Revolution brought a sharp and serious check upon it, bringing down the number of English slavers, clearing, from 167 in 1774 to 28 in 1779, and the tonnage from 17,218 to 3,475 tons. After the war the trade gradually recovered, and by 1786 had reached nearly its former extent. In 1783 the British West Indies received 16,208 Negroes from Africa, and by 1787 the importation had increased to 21,023. In this latter year it was estimated that the British were taking annually from Africa 38,000 slaves; the French, 20,000; the Portuguese, 10,000; the Dutch and Danes, 6,000; a total of 74,000. Manchester alone sent �180,000 annually in goods to Africa in exchange for Negroes."

"The Supression of the African Slave Trade to the United States of America 1638-1870"

W. E. B. Du Bois
(New York, 1896)

Last week's bank earnings confirms our view that 2013 is likely to be uneven when it comes to large financial institutions. Lumpy revenue and even more lumps and surprises in the earnings bucket. And, yes, the results of the TBTF zombie dance girls do tell you a good deal about the future -- if you have but the courage to look upon their faces.

Goldman Sachs hit the ball out of the park by exceeding Street expectations for earnings and revenue both, albeit partly carried atop good investment results. Along with JPMorganChase and Merrill Lynch, GS is among the last men standing in the investment banking segment. Not sure about Morgan Stanley, even with the latest layoffs factored into the mix. When you think of Sell Side firms in 2013, think the Burmese death march with Uncle Ben Bernanke presiding as the weaker, smaller players drop out of the herd and die along the roadside.

Wells Fargo showed balance sheet growth on the commercial side in Q4 2012, but retained $9.7 billion in first mortgage production to maintain the residential portfolio. Hmm, the relevant collateral is trading at, what, a five point premium? Going forward, we are reminded that the yield spread premium opportunity lost when conforming loan production is retained comes out of NIM. But hold that thought�

WFC notes in the highlights of the supplement filed with the SEC, "Gain on sale revenue up $208 million (despite $340 million in forgone revenue resulting from the retention of conforming production)on higher margins and lower repurchase reserve build�" But what will gain on sale revenue, and NIM, look like next quarter?

The fact that the bank with the biggest residential mortgage origination market share actually retained a big chunk of production seems noteworthy. Yet the Big Media barely blinked. The fact that WFC felt the need to disclose this sort of operational mortgage minutiae tells you about the importance of the datapoint.

Then there is the report of the Q4 2012 Bank America earnings, which were really great if you ignored all of the noise emanating from festering legacy mortgage issues. Our fellow traveler Manal Mehta noted "The Most Interesting and Most Important Question on BAC's Earnings Call - From Mike Mayo on Impact of successor liability motion�" The successor liability is with respect to the $8.5 billion settlement proposed by Bank of New York/Mellon and Bank America. The BAC earnings call is excerpted below in italics:


We will go next to the site of Mike Mayo was CLSA. Your line is open.

Q - Mike Mayo: Okay. That's fine. And then going to the mortgage put backs and the - so the Fannie settlement, you got that done. Sounds like you're feeling better about the rep and warranty expense. I think I heard you saying it might go from $300 million to $150 million per quarter, so I sense you're feeling better. I'm trying to reconcile that with what's taking place with the MBIA versus Countrywide court moves; and correct my thinking if anything's wrong here, but I think it's an issue of Bank America's successor liability? Or is Bank America responsible for Countrywide? And as of January 9th and 10th the oral arguments were completed so I understand it's in the hands of Judge Branston [ph], the New York State Supreme Court and the motion says that Bank America is responsible for Countrywide. And if so, I guess that could put the $8.5 billion private label settlement at risk. So my question is, could that $8.5 billion settlement be at risk? Do I understand what's happening in the court correctly? And what happens if the $8.5 billion private label settlement does not go through?

A - Bruce R. Thompson: I think a couple things on that, Mike. First, I think it, from our perspective, the $8.5 billion Gibson Bruns [ph] settlement is going through the court process, would likely get wrapped up sometime in the second quarter or early in the third quarter. And that's completely independent from what's going on at MBIA. With respect to MBIA in the broader monolines, as we've said before, generally with - if you look at geography within the financial statements, the majority of the work that we do and where the monolines are accrued for at this point is within the litigation line item as opposed to within our provision for reps and warranties. And the third thing I would say is that, as it relates to kind of the general rep and warrant question, I think the most important thing to go back to is that virtual - the large majority of everything that was done with the GSEs at this point between our global settlement with Freddie and Countrywide and our global settlement with both Countrywide and Bank of America, with the GSEs just takes away a significant amount of risk relative to where we've been before.

Q - Mayo: So we're really just talking private label at this point?

A - Bruce R. Thompson: You've got the - as I referenced, you've got the several monolines that we're working through on a litigation perspective and then you're right, you've got the private label piece. And I think if you go back to the comments that we made about the geography and the representations and warranties you can see we have a pretty sizable amount set aside to work through the private label exposures.

Q - Mayo: So what is the significance of the decision by Judge Branston [ph] and the New York State Supreme Court? There was a Wall Street Journal article on January 11, some other chatter saying that if this motion goes against you and your team's responsible for the legal liabilities of Countrywide, then that could be a negative event for you. Do you agree with that?

A - Brian T. Moynihan: Mike, I mean we could - I think if you think about this litigation goes back and forth and the judge has a lot of decisions to make in a lot of cases and we'll play it out here. But we're comfortable with our legal positions across the board.

Q - Mayo: Okay. But for that we should - you think we'll hear next month as opposed to midyear?

A - Brian T. Moynihan: I'm not sure the exact time.

Q - Mayo: Okay. Just last question on that because I'm don't - I'm just trying - how do we get our arms around that risk? That's really my question. And so if you wanted to just give advice to somebody, okay here's the potential hit if things go wrong, what would be your answer to that or just - is there no answer?

A - Bruce R. Thompson: I think what you - what I would suggest you do, and I'm not going to quote somebody else's financial statements, but I think you can go look on MBIA's financial statements and see how much that they believe that we're owed - or that they're owed from us. That's disclosed in their financial statement so you can look at that. And then the corollary is I think you have to keep in mind that there is a significant amount of money that they owe us within our Global Market business that's very significant that we have marked at cents on the dollar.

God bless Mike Mayo. How often is he the only analyst on these large bank earnings conference calls asking any relevant questions at all?

Mehta notes that the Bank of New York settlement relies on an opinion by Stanford Law Professor Robert Daines that BAC does not have successor liability for Countrywide. Link below:


The subsequent presentation by MBI destroys that opinion, Mehta believes. Link below:


"If the courts agree, it removes one of the key pillars of support for the Bank of New York $8.5bn settlement," he argues. "If that agreement falls apart, BAC's reserves will have to increase since they are based on the Bank of New York settlement going through."

Later in the week we heard from Citigroup, the House that Sandy built, where mortgage revenue is perhaps less important than any of the top four names. Remarkably, C managed to book over $16 billion in new mortgage originations in Q4 2012, the best quarter since Q1 2012 when the total topped $21 billion. Recall that most of this production sells into a premium market with a credit wrapper from Uncle Sam.

And you did note that net interest revenue on C's total loans is almost 2.3%, yes? And the number has gone up sequentially YOY almost 25bp? Hmmm. You still think that is air you are breathing?

Warning for the future with C and the other TBTF dance queens comes with the mere $142 million reserve release in Q4 2012, down an order of magnitude YOY. This number is probably about as small as it's going to get, so look for the benefit from credit performance to be absent in the future. If anything, C and other banks may need to hike reserve build if loan defaults remain at current levels.

The earnings release at JPM was highlighted by the latest public mea culpa for the London Whale episode. Just to review past comments, the JPM trading activity was not hedging and was part of a deliberate management strategy to earn profits for the bank via this strategy. Credit the Fed, Treasury and FDIC for their various subsidies to the markets in driving the losses at JPM.

Net credit costs were actually positive at JPM in Q4 2012 some $654 million, like the results at C probably as small as this number will be for many quarters to come. The two previous quarters were actually negative because of the magnitude of the reserve releases countenanced by regulators. In this situation, the SEC basically stands by helplessly and waives its arms in protest.

At $46, JPM is trading around book value and well north of the tangible book around $38. Indeed, JPM has added $5 per share to tangible book in the past year and has a return on TCE of 15% according to the bank's earnings presentation.

JPM is the nation's second largest loan originator and third largest servicer, with $51 billion in new originations in Q4 2012 or 2x C. Now you know what we mean when we say that C's approach to the mortgage sector is a mess relative to that of the other zombie girls. Indeed, JPM was making mortgage hay during 2012 while the federal subsidies shined with HAMP and HARP, pushing volumes up 33% YOY.

Look at the charts on Page 20 of the JPM supplement. Does it not look like actual loss rates have bottomed out and are now poised to rise?


Strangely, we keep seeing the same charts in reports on both banks and RMBS. Could this be a mere coincidence?

The fact that nobody wants to mention is that NPLs at JPM have basically been flat for the past five quarters, so the margin for reducing loss reserves is basically non-existent for 2013. With loss reserves just 2x NPLs and down $5 billion at $21 billion at Q4 2012 (the decrease went to the bottom line, of course), JPM may need to actually increase reserve coverage if loan loss rates start to rise again. But of course we all know that loss rates are falling, right?

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