Bank of America (BAC) released earnings Wednesday with a fourth quarter “surge” in profits. The bank reported top-line revenue of $21.7B versus expectations for $2.14B, which sounds pretty good. The bottom line profit numbers looked almost as good with earnings per share (EPS) of 29 cents per share versus expectations of 27 cents per share.
It’s always good to beat expectations and as a result the stock is up. However, this report is not what it seems on the surface. It’s a lot more complicated, and hopefully a lot more useful than the headlines would indicate this morning.
The bad news first…
Banks are funny in the way they report revenue and profits. A major source of bottom line performance can actually come from accounting adjustments to bad debt and loss reserves. These adjustments have very little to do with the bank’s performance and much more to do with its expectations for the performance of its borrowers.
Imagine that you run a small lender and you assume that 5% of your borrowers will not fully pay you back. That 5% can be expensed before they actually default on your loan, which is appropriate and not unusual on its own. However, what happens if you later change your estimate to 3% rather than 5%? You expensed the bad debt already so now you can add it back in as income. This kind of adjustment is where half of BAC’s net income came from in the 4th quarter report.
All of these adjustments sounds like a bit of financial shenanigans, but it really isn’t. It is a common change and can be defended as compliant with accounting standards. The real issue is that the adjustments are a little complex and hard to understand if traders are focused solely on the headline numbers. That is why the early reports from the banks need to be read completely and really understood before making assumptions about the long-term impact on the market.
For example, a little deeper into the BAC report we find that first mortgages (one of the bank’s traditional product lines) are down 50% over the quarter. Ouch! That is a big problem for the bank but it is an even bigger issue for companies that need a strong mortgage market.
On a day that the financials are doing well, its not a surprise that home builders like Pulte (PHM), Lennar (LEN) and Hovnanian (HOV) are struggling. You can see a comparison of the trading activity at Wednesday’s open between PHM and BAC below.
As bad as this data sounds, its not quite unexpected. With rates going up, mortgage origination for new home purchases should be falling. We also know that more mortgage originations have been migrating to smaller lenders, which may make this number look a little worse than reality. However, it’s an important warning for what to watch in the near term.
The good news
Adjustments for loan losses may have pumped up BAC’s earnings this quarter, but there is also a real bright side to that change. Each time a company reports earnings, they also make comments about the future. How confident management is about growth and the economic environment over the next several months can make an even bigger difference in how traders perceive the report.
BAC adjusted loss expectations because they believe the economy is getting stronger. If they think growth is going to be good, then it becomes less likely for borrowers to default. That is a major vote of confidence about the future and should provide some ‘tailwind’ to the market rally this month.
Additionally, trading revenue for BAC and the other banks is much higher than expectations as well. Most analysts had expected declines in those channels but the opposite has happened. Trading revenue is another good indicator for economic activity and represents a legitimate bright spot on the financial statements we have seen so far.
The big bank reports aren’t all out yet and it will then be a few more days before the news is fully ‘digested’ by traders. We will see whether the rally over the last two days can really stick. On the net, we haven’t been blown away by the reports so far, but traders also haven’t been disappointed. It is definitely not time to get bearish, but we expect to see more back and forth in the market in the short term.