UBS' Erika Najarian: Investors are skittish following bankruptcies

Key Concepts

• Non-Depository Financial Institution (NFI) lending: Banks lending to financial entities that are not traditional deposit-taking institutions, often referred to as "shadow banking."
• Shadow Banking: Financial intermediaries that facilitate the creation of credit across the global financial system but whose activities are not subject to regulatory oversight.
• Credit Quality Deterioration: A decline in the ability of borrowers to repay their debts, leading to increased risk for lenders.
• Asset Cap: A regulatory restriction placed on a bank, limiting the total size of its balance sheet, as was the case for Wells Fargo.
• Reserve Build: The act of setting aside funds to cover potential future loan losses, increasing a bank's loan loss reserves.
• Sapphire Reserve: A premium credit card product offered by JP Morgan.
• Net Interest Income (NII): The difference between the interest income a bank earns from its assets (like loans) and the interest it pays on its liabilities (like deposits).
• Return on Equity (ROE): A measure of financial performance calculated by dividing net income by shareholders' equity, indicating how much profit a company generates for each dollar of equity.
• Labor Market Inflation (Comp Expenses): The increase in the cost of employee compensation due to rising wages and benefits in the labor market.

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Investor Concerns and the Outlook for Credit Quality

Following the earnings reports from major banks like JP Morgan, Goldman Sachs, and Wells Fargo, investor sentiment is described as "skittish," largely due to recent bankruptcies such as Arie Kotler and others. The primary concern among investors is the potential for a "turn in credit" in the near future.

A significant shift in focus has occurred, moving away from consumer credit concerns towards Non-Depository Financial Institution (NFI) lending. This involves banks lending to "shadow banking" entities, which then lend to companies. This area of lending is highlighted as a major part of the discussion during the JP Morgan earnings call. Jamie Dimon's notable quote, "If you see a cockroach, there could be others," encapsulates the investor anxiety regarding potential broader credit issues stemming from this less transparent sector.

Erika Najarian, UBS large cap banking consumer finance analyst, emphasizes that "credit quality deteriorating is a single most important and overwhelming catalyst for banks and bank stocks," even if investment banking revenues are strong and loan growth is positive. She notes that NFI exposure, according to regulatory data, now constitutes "14% of money center and large regional loan books" and has "grown significantly," making it a critical area to monitor. Despite these concerns, banks are "extraordinarily well capitalized" and "earning a boatload of money," which serves as the "first line of defense of credit."

JP Morgan's Performance and Stock Reaction

Regarding JP Morgan's recent performance, the reserve build was deemed "pretty reasonable." This is attributed to the successful launch of their Sapphire Reserve credit card, which CFO Jeremy Barnum stated had their "best quarter for net new account originations ever." New credit card loans or lines typically require a "pretty high reserve attached to it," making this a "normal course of business."

JP Morgan's stock decline of approximately 3.5% on the day of the report is attributed to several factors:

1. Technical Trading: Investors may have "cleaned up short positions" the previous day, anticipating a better revenue print.
2. Conservative Outlook: JP Morgan's forward outlook for the next year was perceived as conservative. While consensus for Net Interest Income (NII) was "pretty much in line," consensus for expenses was "a little bit too high."
3. Labor Market Inflation: JP Morgan indicated that "3 to 4%" is a "normal rate of... labor market inflation in terms of comp expenses."
4. Jamie Dimon's "Cockroach" Comment: This statement "could not have made investors feel great," contributing to the negative sentiment. Erika expressed surprise that this concern primarily impacted JP Morgan's stock, given its reputation for "probably the best risk management out there," rather than affecting the broader banking group.

Wells Fargo's Turnaround and Growth Prospects

Wells Fargo's positive story is largely driven by the removal of its asset cap, which had previously restricted its balance sheet growth. Prior to the earnings report, investors favored other banks like Citi or Bank of America. However, Wells Fargo's outlook for Returns on Equity (ROE), projected at "17 to 18% on a tangible basis," and strong Net Interest Income (NII) for the fourth quarter, signals a significant turnaround.

The ability to "grow our balance sheet" and "grow customers without any... shackles" is seen as a "big deal" that will "deliver better returns on capital." This indicates that the market is "just starting to see the beginning or the early innings of what new wells could be in the future."

Conclusion

The banking sector is currently characterized by strong underlying performance from major players like JP Morgan and Wells Fargo, evidenced by robust earnings and strategic product successes (e.g., Sapphire Reserve). However, investor sentiment remains cautious, primarily driven by concerns over potential credit quality deterioration, particularly within the less regulated NFI lending and shadow banking sectors, as highlighted by Jamie Dimon's "cockroach" analogy. While banks are well-capitalized, the market is closely scrutinizing forward-looking statements and broader economic indicators. Wells Fargo stands out with significant growth potential following the removal of its asset cap, signaling a new phase of expansion and improved returns. The overall takeaway is a nuanced picture of strength tempered by underlying credit risk concerns, with a keen focus on how these risks might evolve in the coming quarters.