The beginning of the second-quarter earnings season kicks off this week with the largest U.S. banks, JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), and Wells Fargo (NYSE:WFC) scheduled to report on Friday. Investor focus will be intense, as these results will offer crucial insights into the banking system’s health and even the broader U.S.
The reports follow the edge-of-your-seat drama over the past year with bank failures and economic uncertainty. Analysts will dissect the reports for signs of lingering weakness and potential areas of concern.
Unrealized Losses on Assets
One key area of scrutiny will be unrealized losses on bank balance sheets. According to the Federal Deposit Insurance Corp. (FDIC), banks currently hold a staggering $517 billion in unrealized losses. This stems from the large purchases of government bonds and mortgage-backed securities made during the pandemic when interest rates were low and deposits were high.
As the Federal Reserve raised rates in 2022, the value of these holdings declined, as bonds trade at a discount when rates rise to offer investors higher yields. While most banks don’t need to sell these assets and realize the losses, a forced sale scenario could trigger a liquidity crisis, as evidenced by Silicon Valley Bank’s collapse last year after selling off mortgage bonds at a significant loss. Analysts, however, generally expect these unrealized losses to remain flat in the second quarter, considering the relative stability of the 10-year Treasury yield during that period.
Commercial Real Estate
Another area of concern is the commercial real estate market. Banks are deeply entrenched in this sector, holding an estimated 40-50% of all outstanding commercial real estate debt. Delinquency rates are rising, though they haven’t reached the alarming levels witnessed during the 2008 financial crisis.
However, a recent spate of defaults on commercial mortgage-backed securities has raised fears that delinquencies could climb further. This poses a particular threat to small and regional banks, as they typically hold a larger portion of commercial real estate loans compared to their total assets than their larger counterparts.
Lending Profits
Bank profitability from lending continues to be a challenge. While they generate higher lending profits than post-pandemic, the growth trajectory slows as the economy adjusts to higher interest rates. This slowdown stems from two key factors: First, bank customers are shifting their funds from non-interest-bearing accounts to interest-bearing ones. Second, banks are limited in raising interest rates on loans and other products in response. Consequently, most analysts predict a further decline in net interest margins this quarter.
Liquidity Buffers
Investors will specifically gauge regional banks’ health by looking at their cash and readily available securities. Historically, liquidity levels were similar between big banks and regional banks. However, the trend has shifted, with larger banks accumulating more cash reserves to weather potential deposit declines. This disparity could exacerbate challenges for smaller institutions.
Credit Card Delinquencies
Another area to watch is credit card delinquencies. As some consumers struggle financially, banks are seeing increased missed payments. Analysts anticipate a modest rise in delinquency rates for the second quarter.
Investment Banking Fees
A potential bright spot comes in the form of investment banking fees. These fees are expected to rise year-over-year in the second quarter, driven by increased corporate borrowing activity as borrowing costs have declined. The first quarter already witnessed a strong showing for bank investment banking divisions, marking one of their best quarters since the Fed’s rate hikes began impacting dealmaking in 2022. However, deal volumes haven’t yet returned to the peak levels witnessed in 2021, when low interest rates fueled a surge in acquisitions and debt refinancing.
Key Takeaway
The upcoming earnings reports from major banks will provide valuable insights into the health of the financial system and the broader economy. Investors will look for signs of lingering weakness, particularly in unrealized losses, commercial real estate, and credit card delinquencies. While optimism exists around investment banking fees, the overall picture will likely be cautious navigation in a complex economic environment.
