Why I Shorted The Big 4 Banks
This morning the Big 4 commercial banks – JP Morgan (JPM), Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C) – kicked off 4Q22 earnings season. And while the current results looked fine, I expect the banks to run into problems in 2023.
Let’s start with Net Interest Margin. Banks make money by borrowing from various short term sources and lending out that money long term. The profit they make is the difference between the interest rate they pay and the one they get, or Net Interest Margin. As long term interest rates have risen of late, that has helped banks Net Interest Margin as the interest rate they get for their loans has gone up. For example, JPM’s Net Interest Margin increased to 2.47% in 4Q22 from 2.09% in 3Q22, BAC’s to 2.22% from 2.06%, WFC’s to 3.14% from 2.83% and C’s to 2.38% from 2.31%. That might seem insignificant but it adds up when you have trillions in assets and liabilities. However, I expect long term interest rates to come down this year – and therefore the interest rates banks receive on their loans – as inflation rolls over and we enter a recession. The rates they pay on their short term borrowings will likely increase as well as the Fed holds the Fed Funds Futures Rate as high as possible for as long as possible. In other words, I expect banks’ Net Interest Margin – the core of their profitability – to be squeezed from both sides.
Next let’s turn to Credit Loss Provisions. This is the amount banks set aside to cover loans gone bad. They make estimates based on current trends and take a charge against earnings based on the number they come up with. Credit Loss Provisions increased marginally at the Big 4 in 4Q22. For example, JPM’s increased to $2.288 billion from $1.537 billion. Clearly the Big 4 are anticipating some tougher times ahead – but I don’t think they are anticipating just how tough. The nasty recession I anticipate will put pressure on borrowers and lead to a significant increase in deliquencies and defaults. The second part of my bear thesis therefore is a significant increase in Credit Loss Provisions. Combined with Net Interest Margins being squeezed, this will put bank profits in a vice grip.
So while JPM may look reasonably valued at 12x 2022 EPs of $12, it looks more expensive if you expect bank earnings to shrink by 20-30% this year. I fail to see how bank stocks won’t be hit by the nasty recession I see on the horizon.