- Banks' earnings were one of several factors helping boost global stocks last week.
- Profits earned by major US banks in the second quarter so far have been eye-popping.
- A healthy banking sector is a key component of a healthy economy.
- But with all the uncertainties surrounding bank shares, don't expect Financials to lead the market.
Global stocks finished up a whopping +6.6% last week (+7.0% for US stocks). The tailwind came from what many might consider an unlikely source: bank earnings. Just months ago, calls for bank nationalizations were widespread. Today, many of those same banks are making money hand over fist.
Major banks' earnings in the second quarter so far have been eye-popping. Goldman Sachs, a relative newcomer to the world of commercial banking, kicked the week off by announcing second quarter earnings of $3.4 billion—their most ever as a public company. JP Morgan followed with earnings of $2.7 billion. And Friday, Citigroup and Bank of America reported quarterly profits of $4.3 billion and $3.2 billion, respectively.
How did they do it? Not by peddling complex financial products or using excessive leverage. Most of those profits came from old-fashioned capital markets activities: lending, trading, investment banking, etc. As always, there were one-time items that added or detracted from bank earnings, but it's clear traditional banking capabilities are intact. These are the basic functions that support a vibrant economy.
Also positively, a number of banks are already breaking free of their TARP* shackles by repaying the government…and then some. The TARP program was inherently flawed from the start (as most government programs are), but it hasn't been the $700 billion money pit skeptics portrayed. In fact, taxpayers have so far earned a healthy return on their investment.
Despite these successes, all is far from clear on the banking front. For example, CIT Group, a former commercial banking powerhouse, flirted with bankruptcy as the Fed denied the bank access to liquidity programs. BofA CEO Ken Lewis had what was undoubtedly a less-than-cozy reunion with former Treasury Secretary Henry Paulson on Capitol Hill as Congress grilled the two over details surrounding BofA's Merrill Lynch acquisition. And share dilution in the Financials sector has been massive. More than a third of Citi will soon be owned by the government, and BofA has increased its share count by nearly two-thirds recently to boost its capital base. In the UK, Prime Minister Gordon Brown has suggested withholding bonuses from Financials executives for five years. And banks across the board are dealing with rising loan delinquency and default rates and more impending regulation. The list of uncertainties surrounding Financials seems nearly endless, a fact likely to weigh on share prices in the sector relative to the broader market for some time.
Fortunately, none of these hurdles inhibit banks' ability to supply needed capital to the economy. It's important to separate banks' capacity to conduct their core banking business and the prospects for bank stocks. The former has shown significant improvement to the benefit of the US and global economies. The latter is much less certain. As a result, financial stocks may lag, but that shouldn't hinder a broader economic or market rebound.
*Troubled Asset Relief Program