1st Qtr Bank Profits Break Records (Apr. 23)

Update 265 — 1st Qtr Bank Profits Break Records
But Markets Skeptical: Is an Encore in Store?

With the last of the financial sector’s quarterly earnings reports for 1Q18 trickling in, we take a look at the condition of the large and diverse financial sector in the United States.  

What we find is a sector whose largest institutions almost all report recording-breaking if circumstantial profits. Analysts and some bank executives cast doubt though on the sustainability of the performance. Still, the banks’ performance begs the $2155-dollar question: why deregulate under these conditions?

Best,

Dana

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Wall Street Gets a Tax Break, Sheds Risk

The Wall Street giants emerged from the financial crisis bigger and more profitable than ever.  Over the past ten years, the three largest banks by assets — JPMorgan Chase, Bank of America, and Wells Fargo — have added more than $2.4 trillion in domestic deposits.

Net income at JPMorgan Chase, the nation’s largest bank by assets and deposits, rose 35 percent to $8.71 billion.  Corporate tax cuts helped the six largest U.S. banks produce a combined net income that surpassed $30 billion for the first time ever.  The new corporate tax rate has saved the six largest banks about $2.9 billion thus far, contributing a ten percent increase in quarterly net profit.  The tax cuts are supposed to spur economic activity, such as lending and hiring. But loans at the four largest commercial lenders fell $2.5 billion last quarter and the combined loan count was below where it was a year earlier.

Can Wall Street Repeat?

The financial sector’s earning season that just ended makes clear the condition of its largest institutions, measured by annual profits. Along with the massive tax savings, the main factors behind Wall Street profits over the last 12 months have been:

• Trading Activity:  Trading revenue was the highest in three years as they capitalized on volatile equity markets.  Volatility in the markets came in and helped the equity trading. In particular, equity derivatives benefited Bank of America and others. Rising interest rates fueled revenue derived from lending.  Equity trading led, with every investment bank blowing past expectations in the most volatile quarter in years — even with U.S. stocks seeing the worst single-day plunge in almost seven years in early February.

• Interest Income: JPMorgan, Bank of America and Citigroup benefited as the Federal Reserve raised rates twice in the past four months, meaning they can charge more for loans.  All three firms posted higher net interest income in the first three months of the year, which they attributed to higher rates and loan growth.

• FinTech: Customers’ increasing acceptance of digital products and tools. Before online and mobile banking became popular, consumers generally opened a new account at the bank with the nearest branch; with more banking transactions done online or through smartphones, customers are picking national banks because of their well-known brands and the perception that their technology products are superior.

• Credit Quality: Credit quality remains a top concern for investors as Federal Deposit Insurance Corp. (FDIC) data shows credit-card loans reached a record last year. Bank of America and JP Morgan Chase both saw write-offs climb about eight percent, attributing the increase to souring credit-card loans. Citigroup warned that its cost of credit will likely increase in the current quarter. Regardless, all of the banks say consumer credit quality is holding up well amid low unemployment.  JPMorgan had to set aside more money to cover potentially bad loans, and the bank’s total charge-off rate — the percentage of loans it expects are not likely to be repaid — climbed to 1.20 percent of all loans. That compares to 1.07 percent of loans in 2Q17.

The following might put the profit margins on Wall Street in perspective. Wells Fargo announced a one-off write-down last week of $800 million to cover losses associated with its settlement with regulators. The firm’s tax savings from the first quarter alone came to $636 million, 80 percent of Wells’ settlement charge.
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Source: http://www.wsj.com/graphics/bank-earnings/

Can Wall Street repeat this performance?  Citigroup Chief Financial Officer John Gerspach said last week that businesses had only begun taking advantage of the changes: “I think the best is yet to come.”

Community Banks Profitability Also Up

Having locked in long term loans at favorable interest rates, big banks have also taken steps to move risk off of their balance sheets.  As a result of this interest rate environment and competitive lending conditions, riskier assets have moved further down the industry as smaller, mainstreet financial institutions have “reached for yields.”

At first glance, the nation’s 5,700 community banks, with nearly $5 trillion in assets and record profits, appear to be as healthy as they have ever been.  Despite record profits, there is evidence suggesting some community banks are distributing lower quality loans in search of higher yields.

Some analysts are concerned that this combined with dangerous mortgage loans could increase risk in the community banking sector.  A provision in S.2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act, would grant relief for banks with under $10 billion from the Volcker Rule and Qualified Mortgage safe harbor, opening the door for community banks to make riskier mortgage loans. The good news is that while individual banks may overextend themselves, community banks pose far less systemic risk than their larger counterparts.

Regional Bank Euphoria
 

While fewer than ten regional banks have announced their first quarter 2018 earnings reports, the results have been favorable for these institutions thus far. Comerica and KeyCorp each reported substantial increases in adjusted net income year over year. Northern Trust’s Q1 earnings totaled $381.6 million vs. $276.1 million the year prior. BB&T’s quarterly earnings are up 22 percent, compared to 4Q17.

Some institutions will see some short-term pain in exchange for long-term gain with the recognition of past tax deferrals. For instance, BMO Financial’s 1Q18 net income fell 35 percent due to the revaluation of its deferred tax asset of $425 million. This upfront charge will be more than worth it for BMO going forward as the company can now claim a significantly decreased tax rate.

If it passes the House, S.2155 is one of the biggest gifts the regional banking sector could have asked for. In raising the threshold for automatic enhanced prudential standards from $50 billion to $250 billion, the bill would allow regional banks to devote fewer resources to maintaining required capital buffers, complying with stress testing, and submitting resolution plans. In the short term, this will benefit these banks, but increased systemic risk could harm the financial system in the medium to longer term. Regional banks tend to have similar balance sheets, so while profit is strong at present, this class of banks rises and falls together.

The Sectoral Landscape 
 

The U.S. financial sector is far more stable than it was a decade ago.  Record profits, bolstered by the Republican corporate tax cut, do not appear to hide the same kind of asset bubbles, no-doc lending practices, and others risks that accompanied but went largely missed or ignored in the run up to the 2008 crisis.

The strength and stability of the financial system is thanks in no small part to post-crisis regulations. But industry lobbyists are presently hard at work taking aim at Dodd-Frank’s systemic risk protections via S.2155.

Even regulators themselves — the steadily increasing number of Trump-appointed ones at least — are not so much diligently applying lessons learned but are designing new federal rules to relax critical capital buffers, the leverage ratio, and stress testing.

More to come this week.

K Street Prowess on Full Display (Apr. 6)

Update 261 – K Street Prowess on Full Display


In the Drafting and Influencing of the TJLA

Experts and veteran observers were horrified at how quickly the Republicans pushed the massive Tax Cuts and Jobs Act (TCJA) through Congress. Tax legislation is notoriously complicated and witnesses to the sausage making braced themselves for unconsidered but devastating consequences.

The Republican haste should hardly be surprising: their donors and the K Street lobbyists they employ saw a once in a generation chance to change the tax code to their advantage and they were not going to miss out.  A drill-down on the $1.5 trillion deficit-financed feeding frenzy follows.

Happy Friday,

Dana

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A few Republicans were honest about where the pressure for such rapid legislation came from. Sen. Lindsey Graham expressed concern that “contributions will stop” if the TCJA was not passed, and Rep. Chris Collins said that “donors are basically saying ‘get it done’ or don’t ever call me again.”

In all, more than half of D.C.’s 11,000 lobbyists worked on the tax bill, donating $9.6 million to members of Congress during the first nine months of 2017.  20 corporations and trade associations have hired at least 50 lobbyists apiece. The U.S. Chamber of Commerce hired the most lobbyists to work on tax issues, and the Business Roundtable, an association of CEOs of the nation’s largest corporations, hired 51 lobbyists.

Who Got Goodies

It is common for large and complex pieces of legislation to come with a handful of provisions that were clearly intended to help one specific industry.  The TCJA, written by Republicans behind closed doors with more contact with K Street lobbyists than their Democratic colleagues, might well set records in this regard. Here are some of the most blatant giveaways.

•  Craft brewers: Trade organizations representing the craft beer and wine industry got a welcome handout from Senator Rob Portman who slipped in the “Craft Beverage Beer Modernization and Tax Reform” provision into the bill, lowering the tax rate on American-based alcohol producers.

•  Aircraft owners: The TCJA provided a generous expensing provision for aircrafts. It replaced the longstanding “like-like” exchange provision with a short-term provision that allows for immediate expensing. Beyond this, the Act stipulated that a federal excise tax is not due on amounts paid by aircraft owners to aircraft management companies.

•  Oil and Gas Industry: The oil and gas industry’s long standing wish finally came true when Sen. Lisa Murkowski pledged her support for the bill in exchange for the opening up of the Arctic National Wildlife Refuge for drilling. The provision, which opens up the 19.6 million acre reserve oil and gas exploration, will certainly be a boon for the industry.  Experts estimate the region could hold as much as 20 billion gallons of oil.

•  Real Estate: The doubling of the standard deduction left homebuilders concerned that fewer tax day itemizers would translate into more expensive homes and fewer new homebuyers.  While at this point it is unclear just what effect the decline in itemizers will have on home buying, real estate interests got more than enough goodies elsewhere in the bill to make up for market rouble. Real estate firms won special treatment regarding the limits on the deductibility of interest expense, and an eleventh hour addition gave them special access to the 29.6 percent pass through rate.  And real estate investment trusts (REITs) got special treatment under the law, also thanks to a last minute addition.

Shootout @ PayGo Corral — Lobbying for Loopholes

K Street’s greatest impact, however, may have been in the loopholes they were able to save as Republicans rushed the TCJA towards the finish line. In order to keep costs in line with their $1.5 trillion dollar spending limit, Republicans had to find a number of ways to raise revenues by closing existing loopholes. For lobbyists, this turned into a scramble to protect their industry’s favorite loopholes and pass the pay-fors off to someone else (typically middle class taxpayers).

•  GE and Friends: The House’s version of the then-bill sent lobbyists for General Electric (GE) scrambling.  A provision in that version of the bill would have disallowed GE and other firms from deducting the losses from some overseas units from the one-time repatriation tax on foreign earnings. Lobbyists mobilized quickly and the provision did not make it into the final Act.

•  Oil and Gas win again: Oil and gas companies have long been able to immediately deduct the cost of their drilling operations from their taxable income. At various points tax drafters considered eliminating the tax break that opponents deride as a warrantless handout. Yet the industry’s lobby was fierce, and the deduction survived.

•  Private equity payment protection: President Trump had long railed against the carried interest preference, making the loophole a central feature of his campaign rhetoric. Despite this, the provision made it through the TCJA mostly unscathed. The required period that fund managers must hold their stock to gain access to the loophole was extended from one to three years, but many observers see this as window dressing (see update 260).

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The End Result

All this lobbying paid dividends for corporations, but little of the gains have found their way to rank and file workers. Leaders from the nation’s largest unions have argued that low wage workers have received little benefit from the TCJA. February did see strong job gains, with the economy adding 313,000 new positions, but wage growth has remained flat since passage of the Republican tax overhaul. While it is unclear whether wages will pick up in the coming months, it is clear that shareholders have benefited mightily. Corporations have spent $218 billion buying back their own stock since the passage of the TCJA, with more share repurchases on the way.

Republicans in Congress have also been able to cash in on their efforts as donor contributions have continued to pick up since November. Frustrated with Washington gridlock and the GOP’s inability to accomplish longstanding legislative goals during President Trump’s first year in office, several Republican mega donors began to withhold fundraising dollars. Getting the TCJA over the finish line was enough to turn the campaign-finance spigots back on.

Shortly after the tax Act became law, Charles and Elizabeth Koch wrote the first big check of the midterm cycle, giving $1 million in late November. Other large donors quickly followed suit.

Ahead:  Technical Corrections Lobbying

While last month’s omnibus included an important fix for the grain glitch, there is still substantial work to do before the tax code is rid of the unintended consequences in the TCJA. However, opening up the hood to tinker with the bill will be an uphill battle for Republicans, because it is seen as dangerous by Democrats, and would give K Street another opportunity to run up the score.

While the TCJA was passed through reconciliation, only requiring 51 votes, any alterations will have to beat back a Democratic filibuster. For reference, after the Democrats passed Obamacare they were never able to conduct a thorough correction process because Republicans held ranks and filibustered. It is unlikely that either side will compromise on taxes this far into the election year.

House Speaker Paul Ryan seems appropriately skeptical of Tax 2.0’s chances this cycle, but Kevin Brady has suggested he will introduce it by tax day, April 17 this year; consider it a two-day extension for free.