Earnings JPM & WFC

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The market rallied and pushed right up into, and in some cases above, those resistance levels. The big driver yesterday came from Bernanke’s speech after the market close on Wednesday. As I mentioned, there was something in his speech for everyone. First,they are kicking the taper can down the road from 2013 to the first quarter 2014, until they kick the can again. That helped fueled the bond market, driving bond prices higher and pushed yields lower. Then, he mentioned that inflation was not high enough and that deflation was dangerous; that helped fuel the gold and silver market off the recent lows. Now, we may be able to focus back on earnings. Today we have a couple of big banks, JPMorgan (JPM) and Wells Fargo (WFC), reporting.


Earnings: JPM and WFC

The banking sector has been at the core of the financial crisis and, in some cases, the line between the private sector and nationalization has blurred. That couldn’t ring more true than in the banking sector. While many banks certainly wanted to remain autonomous, especially during the distribution of TARP, they also didn’t shy away from some of the huge changes in accounting rules that certainly benefited their reporting ability. Many banks have paid back their TARP money, while others are still deeply involved with government intervention. The accounting rules, however, are here to stay. The biggest benefits with these accounting changes have been in how to mark (value) assets on the book and marking which assets can be used as bank reserves.


Gaming Accounting Rules
The most recent and egregious use of these accounting rules has been by Freddie Mac and Fanny Mae, the two Government Sponsored Entities (GSE) that are now nationalized and owned by the government. At the start of the financial crisis they wrote down 100% of their assets’ value to ZERO. This allowed them to take a massive charge and also receive 100′s of billions in tax payer bailout. This year they marked those assets back to market value and reported a HUGE profit ($60 billion). Yet it was not really a profit, but just an accounting game. No one actually believed the bankrupt Freddie and Fannie, now fully government owned, made more money in actual profit then they ever had in this economy and housing market. And the truth is they didn’t; it was just a gaming of the accounting rules to report a profit. The stocks Freddie and Fannie still exist, even though they filed bankruptcy and are majority owned by the government. They are listed on the OTC market (penny stocks). Since they are still considered public companies, they are allowed to use the accounting rules that had been changed for the banking sector, primarily the “mark-to-market” and value asset adjustments. They just mark the value of their Mortgage Back Securities (MBS) up significantly and reported a profit. However, and here is the biggest part of the gaming of the market value, the actual buyers of all these MBS’s is none other than the Federal Reserve. As reported by Fed President Fisher, by the end of summer the Federal Reserve will be the buyer of 100% of all MBS new issuance. The Fed buys the MBS’s and Freddie/Fannie mark the value of their MBS’s to the market and bingo you have a profit. The truth is that no one, other than the Fed is actually buying them and no one actually wants to buy them either.


Bail Out Wagon

The above is not only the most egregious use of the accounting rules, but also exposes the reality that the banks are also able to mark their MBS’s as well. Additionally, the Fed is picking up the slack in under-performing assets and has become the net buyer of all new MBS issuance. What is the Fed doing in the MBS market in the first place? It is not really helping the economy, but rather letting the banks continue to operate and unload risk off their balance sheet onto the Fed and also mark assets to a questionable value.

Recently we have seen the FDIC push for even higher bank reserves and, while the Banks and Fed are not totally on board, it seems they have come to a level of compromise. This just shows that even the FDIC is not totally comfortable with the accounting rules, allowing for certain assets to be used as collateral and the mark-to-market accounting (especially the MBS’s).


Earnings

So as we review bank earnings this season, the Freddie/Fannie, Fed, FDIC, and accounting rules should be freshly in your mind and taken under consideration.

JPMorgan
Courtesy of Wikipedia

JPMorgan (JPM) has gotten past the dark shadow of the “London Whale” that plagued them last year. The company reported $24.84 billion in top line revenue, up from $22 billion a year ago. The company reported a $6.5 billion profit ($1.60 a share), better than expectations, but as analysts look through the data, some are stating it’s not that they beat, but how they beat that they have a problem with. There was a mixed picture with equities and fixed income revenue up 18%, but the private equity loss was $522 million and mortgage bank income was down 14%. The short-falls were net-interest margin, net-interest income, and loan growth. Some analysts have stated that JPM beat estimates because of some of the accounting “fluff” that I laid out above. No doubt that top line revenue is growing, but unlike other businesses, the banking sector is deep in the accounting game, which makes it hard to understand both the risk as well as actual profits from “paper” profits. The stock is unchanged in the pre-market; even with the upside surprise beat in earnings.


Wells Fargo
Courtesy of wikipedia

Wells Fargo (WFC) is the biggest U.S. mortgage lender. Revenue edged up slightly from $21.29 billion to $21.4 billion, which beat expectations on revenue growth. The earnings per share saw a 20% raise in profits on a year-over-year basis, to 98 cents a share, up from 82 cents a year ago. They saw loan growth at 3.4% and loan losses continue to decline. Non-interest income from the bank fell 3% and mortgage applications pending fell 15%. The story was slight different from JPM, but Wells Fargo has heavier focus on the loan side, whereas JPM is more focused on the non-interest income side of the business. WFC is up slightly in the pre-market. Wells Fargo has also benefited from the accounting changes adopted over the Great Recession and there remain questions in the MBS arena and mark-to-market accounting.


Both of these stocks, as well as many other financials, have moved higher. The one shadow hanging over the banking sector is the recent rise in mortgage rates (as interest rates climb) and also the slow-down in mortgage applications. This will most likely hit companies like Wells Fargo more so than JP Morgan, as they are heavily into the mortgage market. The problem with relying on mortgage growth continuing to remain strong is the foot-print of customers. Remember, back in the pre-2008 era anyone with a pulse could get a mortgage, now the market is far tighter and gone are the days of “interest-only”, “80/20”, and other creative financing solutions. Now you need income, little debt, and the ability to put 10-20% down. That limits the foot print of possible buyers. One real-estate analyst on CNBC stated that we could see a slowdown in both sales and loan demand, with housing price growth paring slightly, as the last couple of years of capable buyers are meeting capacity. The problem reverts back to Supply and Demand; we still have lots of inventory and of the capable buyers, we have gutted out a huge amount because of their credit worthiness, income, and ability to put down a significant amount. This is not to say we are in for another housing crash, as I don’t think we are, it is simply to point out that the growth rate in sales, price, and mortgages may slow. If it does slow that can impact future revenue for interest-income reliant banking sectors, predominately those heavily in the mortgage loan sector.


Really?
I think we are getting to the days where huge upside beats are no longer surprising and come under more skepticism. I am still amazed that many actually believe that Freddie and Fannie (penny stocks, that filed bankruptcy, owned by the government, and also relying on the Fed to purchase 100% of MBS) actually made their reported $60 billion in profit. The irony is that they reported the billions in profit, but don’t have billions to make the payment they owe to the Treasury as part of the bailout deal. It will again be an accounting game. So far the masses believe it, but then again the masses don’t bother to do the math and just believe the headline news. It sure is interesting how this whopping profit from Freddie and Fannie came just in time to save the nation from a deficit ceiling debate and report a surplus. You know that Jamie Dimon (CEO of JP Morgan) would be jealous of Freddie/Fannie profits, but then again he knows they aren’t real, because he knows how the accounting game works.

I personally think there is some strong growth to come in the banking sector, but until we can fully understand the risk, Dodd-Frank, and the accounting game, it is a little hard to separate out fantasy vs. reality. Again, it’s perception that drives price.


Support & Resistance

INDU 15,400 – 15,500
We are in a critical area of resistance. We should expect to see some resistance in here. While Bernanke gave us another 9-12 month gift of more asset purchases, we also need to be a little realistic about growth. If we can punch through the 15,500 level we should see a surge higher. Expect some resistance in here.

NDX 3030+
BOOM! When this index wants to move, it does, like no other. I have seen this index make bigger gap moves than any other index. It is loaded with the top tech stocks and those stocks are naturally volatile. It is also an index that is top heavy with some over-weights. Get Apple or Microsoft to make a big move and it can drag the entire sector kicking and screaming with it. This index has vacuum moves up and down, which can get violent and cause over-reaction. 3030 looks like it could now be support, but if we come back down we could also fill that gap and drop back to 3000. I would expect volatility and continue to track over-weights in this index.

SPX 1680
We are right there at that key resistance point that many are watching. The VIX is falling, dropping down below 14; however, it is still higher than one would think as this index bolts up towards a resistance level.

RUT 1000+
I don’t know where the resistance would be, if there is any. We need a stall and a pull back with some consolidation before we can start calling resistance points. As we look back over the last couple of weeks and I track the RUT, the RUT has proven to be the indicator to follow. It continues to move higher, breaking above recent highs, and not stopping. Clearly, the other indices snapped back to a mean reversion yesterday to the RUT, which again just shows that order flow continues to march into equities.


Hey, QE worked; QE3 really worked – that is if one is to measure the reaction of the market (bonds and equities). A hint of a stop or even a slowdown in QE and the market derails and starts selling off. I think Wall Street is sending Bernanke and his Doves a big “Thank You” card for kicking the tapering into 2014.

The Empire Strikes Back

Meanwhile, our favorite ideologue-academic Senator, Elizabeth Warren, wants to reintroduce Glass-Steagall. The Glass-Steagal Act came about in 1933 during the Great Depression. Many were trying to find someone to blame for the Market Crash and the Great Depression. Glass-Steagal was legislation that broke-up the banks and separated commercial and investment banks. However, nothing was done to address leveraged debt or debt. While Glass-Steagal was repealed in 1998, many of the rules and how it was intended were dead by the 1960′s.

One of the problems of the Dodd-Frank and Warren’s Bill to bring back Glass-Steagal, is government intervention and “fixes”. One example was that Glass-Steagal had put interest limits in place for commercial banks, but in the 60′s people started withdrawing capital in droves from commercial banks to take advantage of higher market interest rates and better return. The Glass-Steagal act hamstrung banks, where many faced problems with deposits and loans. The government stepped in and changed the rate to help, but again it was government intervention and what amounted to “price fixing”, which the banks were forced to live with.

Meanwhile, on the investment bank side of the equation, they were not under the stricter acts from Glass-Steagal and were able to change and adapt to market conditions. By the 1970′s Merrill Lunch introduced the “cash management account”, where clients could actually write checks and use their “investment” accounts like a bank account. Again, it was a huge blow to the commercial banks, who continued to compete with the investment banks and had to go back to Congress and regulators for each interest rate change, ceiling, and loan rules.

The laws of Supply and Demand ripped down the walls of over-government regulations and Glass-Steagal, long before it was repealed in 1998.

It wasn’t Republicans, Democrats, or investment banks that forced Glass-Steagal into history; it was the DEMAND from consumers, the people, which created the Supply for such efforts.
It is easy to see that as long as you live in a FREE MARKET economy, over regulation will constantly be repealed as the drivers of a FREE MARKET economy are Supply and Demand tear them down.

We may see Dodd-Frank and now Warren’s Bill try to man-handle, constrain, and over-regulate the markets; however, as a once famous princess said to the villainous Governor who tried to control the Empire with central planning and control, “The more you tighten your grip, Tarkin, the more star systems will slip through your fingers.” She was right, and as the likes of Warren try to tighten their grip, the more they will eventually lose control.


Princess Leia
Courtesy of Wikipedia

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