JPMorgan Chase & Co. (JPM) kicked off earnings season for the big banks on Wednesday morning, and its quarterly report confirmed that, while the banks are by no means down and out, they do face a difficult uphill battle moving forward.
In fact, to get back up to full speed, the big banks are going to have to clear two big hurdles:
- Increased energy-sector exposure
- Low net interest margin
While the steep, prolonged decline in the price of oil has certainly taken its toll on the energy sector, it has also had knock-on effects that have reached deep into the financial sector. The problem is that the cheap oil that is hurting energy-company revenues is the same cheap oil that has been pledged as collateral against massive loans the energy companies have taken from the banks.
When an oil company wants to drill for oil, it conducts a survey to determine how much oil is underground and how much it could realistically access. Once it has done this, it takes the numbers to the bank.
The bank then looks at the numbers to determine how confident they feel in the estimates regarding the amount the oil company believes it is going to be able to pull out of the ground. It then looks forward to estimate how much it believes that oil is going to be worth over the next several years when it actually does come out of the ground because it will be through the revenue generated by the sale of that oil that the bank will be paid back.
Energy-Sector Exposure Puts JPM and Other Big Banks at Risk
Once it has done so, the bank then extends a line of credit — typically with a loan-to-value ratio somewhere in the neighborhood of 60%. This means that if an oil company believes (and the bank agrees) that there is $1 billion worth of oil underground, the bank will give the company a line of credit worth $600 million to buy the equipment and pay the employees it will need to extract the oil.
So how much exposure do the large banks have to the energy sector?
According to Barclays, Citigroup Inc (C) has nearly $40 billion in unfunded loans, JPM has nearly $30 billion, Wells Fargo & Co (WFC) has nearly $25 billion, Bank of America Corp (BAC) has just over $20 billion, Morgan Stanley (MS) has just over $10 billion and Goldman Sachs Group Inc (GS) has just under $10 billion.
That’s an incredible amount of exposure, especially when you consider how much less the underlying oil is worth than it was when the loans were first extended. In fact, many loans that used to have an LTV ratio of 60% based on previous assumptions of how high oil prices would be in the future now have an LTV ratio greater than 100%.
This puts the banks in a real bind. If the oil companies can’t generate enough revenue to pay off their loans, the banks are going to have to deal with the defaults.
The difference between the rate a bank pays its depositors and the rate it charges its borrowers is called the net interest margin. A wide margin means higher profits, while a narrow margin means lower profits.
The slope of the U.S. Treasury yield curve dictates the net interest margin because banks normally pay shorter-term interest rates on deposits and charge longer-term interest rates on loans. This means that if the yield curve is steep — meaning longer-term interest rates are much higher than shorter-term interest rates — the net interest margin will be wider.
On the flip side, if the yield curve is flat — meaning longer-term interest rates aren’t much higher than shorter-term interest rates — the net interest margin will be narrower.
Unfortunately for the big banks, the net interest margin in the U.S. has been declining since 2010.
It is starting to move slightly higher — JPM reported its net interest margin rose to 2.3% last quarter, up from 2.23% in the fourth-quarter of 2015 and 2.07% in the first-quarter of 2015 — but it is still at lackluster levels for generating much revenue growth.
This is a busy earnings week for the big banks. JPM reported better-than-expected earnings on Wednesday morning, BAC and WFC are scheduled to report on Thursday morning, C is expected to report on Friday morning, MS is scheduled for next Monday morning and GS is on deck to report before the open next Tuesday.
If they are all able to beat analyst expectations — like JPM stock did — it could be a good week for the big banks. With expectations set so low this quarter, it’s going to be an uphill battle, but it certainly isn’t an insurmountable one.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
