The banking "recovery" is less than it seems from earnings

07/20/2009 9:51 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

We’ve got half a banking recovery. That’s not at all the same as being halfway through a banking recovery. What the second quarter results from Goldman Sachs (GS), JP Morgan Chase (JPM), Citigroup (C), and Bank of America (BAC) tell us is that profits from the investment banking side of banking—arranging financing for big company clients—and trading are back big time. But the other side of banking—the bread and butter business of making commercial loans, lending to credit card holders, and the like is still bleeding oceans of red ink.

What we’ve got now is a banking sector rigidly divided into winners and losers. Worryingly for investors inclined to pile into the winners, the profits from the businesses that are thriving right now are way more volatile than those from the stodgier traditional parts of banking. You’ve got to wonder if Goldman and JP Morgan Chase can keep it going and for how long given the normal ups and downs of investment banking and trading.

Let’s start with the poster children for the struggling side of banking, Citigroup and Bank of America.

Citigroup reported second quarter net income of $4.3 billion. A profit! So how bad can things be?

Plenty. That profit is a result of the one-time $6.7 billion after-tax gain from selling part of its Smith Barney brokerage unit to Morgan Stanley (MS). Strip out that gain—and for fairness the $1.6 billion in one-time losses that a rather bizarre accounting rule forced Citigroup to take on its own debt this quarter—and you’re left with a pre-tax loss of $4.2 billion.

Where did the red ink come from? The bank reported $8.4 billion in net credit losses—that’s losses from loans of all kinds, including credit cards. To offset future losses, Citigroup put another $3.9 billion into its loan loss reserves. Over all, operating income from continuing operations fell by 11%.

The picture at Bank of America was remarkably similar. But worse.

A big gain from the sale of the bank’s stake in China Construction Bank boosted earnings by $5.3 billion. Another sale, of its share of a payment solutions company, brought in another $3.8 billion.

On the other side of the ledger, the one colored red, the bank showed $8.7 billion in net credit losses and added $13.4 billion to reserves. The worst damage came from credit cards where the bank said it wasn’t collecting payments on 11.7% of its cards. That’s up from 8.6% in the previous quarter.

That’s not to say that there weren’t bright spots at the two banks. Citigroup’s investment banking and trading business showed a 16% increase in operating income and Bank of America’s Merrill Lynch unit generated $5 billion in revenue.

As you’d expect from those results, banks that have done a better job at controlling their loan losses—such as JP Morgan Chase—or that are mostly investment banks—such as Goldman Sachs—reported much, much better numbers. Goldman Sachs reported record earnings in the quarter of $3.4 billion, a 65% increase from the second quarter of 2008. JP Morgan Chase, like Bank of America and Citigroup, reported continued deterioration in its loan portfolio. But in comparison to those two banks, the losses were relatively minor. The bank added just $2 billion to its loan loss reserves in the quarter. And that was outweighed by a huge surge, an increase of 62% from the first quarter of 2009, of in fees from its investment banking business.

So where does the sector go from here? On July 22 when Wells Fargo (WFC) and US Bancorp (USB) report, investors will get to see if other big banks are holding the line on credit losses like JP Morgan Chase. That would be good news for the sector as a whole and a sign that the really damaged bread and butter banking business is stabilizing.

We’ll have to wait until next quarter, I’m afraid to see if the big gains in investment banking and trading at Goldman Sachs and JP Morgan Chase can continue at anything like this pace. There were worrying signs in the Goldman Sachs results, as superlative as they were. Fees from advice to corporate clients was down by about 50% from the same quarter in 2008, for example, and the huge profits from the trading business are a result of residual turmoil in the fixed income, currency, and commodity markets and resulting big spreads. You’d expect those spreads—and Goldman’s profits—to decline as the sector’s health improves.

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