US Banks: Expect JPM Net Interest Margin to Increase 25% by 2015

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

July 28, 2013

US Banks: Expect JPM Net Interest Margin to Increase 25% by 2015

  • We believe JPM’s net interest margin has troughed at 2.6% in Q2 (on a core basis – i.e. excluding the impact of the trading book), and will increase to 3.2% by 2015.
    • This 25% increase over 2 years, combined with expected growth in earning assets of 6%, will generate an annual increase in net interest income (accounting for approximately one-half of bank revenue) of 15%+.
    • We note the core net interest margin was 3.3% as recently as 2011(see Exhibit below), and this was itself a 5-year+ low.
  • This February, management forecast the margin to trough in 2014Q1 but this has likely been brought forward by a combination of growth in the real estate portfolio (as new loans now exceed run-off from legacy portfolios) and accelerated compliance with LCR requirements.
    • LCR (“liquidity coverage ratio”) compliance appears to have driven an extraordinary Q2 increase of $100bn to $265bn of deposits-with-banks accounting for substantially all the linked-quarter growth in earning assets.
  • The components of our forecast for a 60 basis point margin increase are: 60 basis points from curve steepening and 40 basis points from deposit spread widening with an offset of 40 basis points from loan spread compression and other factors.
    • The forecast impact from curve-steepening and deposit spreads are based on the 2015 rate environment implied by forward markets.
    • The forecast impact from loan spreads assumes intensifying competition although it may prove conservative as JPM rebuilds its residential real estate portfolio (accounting for only 28% of loans versus ~40% at WFC and BAC and an industry-average of 30%).

Exhibit: Net Interest Margin Components for JPM as % Core Avg. Earning Assets

Overview

At an Investor Day in February, JPM called for its net interest margin to trough/stabilize in 2014Q1 based on the then-forward rate-curve and expectations for spread compression on both deposits and loans, as well as an adverse mix-shift in the balance sheet towards HQLA (“high quality liquid assets”) to meet the new LCR (“liquidity coverage ratio”) standards set by regulators.

In practice, we believe the net interest margin troughed last quarter at 2.6% on a core basis (i.e. excluding trading) and will increase to an average 3.2% in 2015; a key driver is the 60 basis point steepening of the curve between the 3-year swap rate and 6-month Libor discounted by the forward markets for between now and end-2014 (see Exhibit 1). As we move into 2014, we expect firming short rates to provide support through lifting the margin contribution of deposits by 40 basis points; we are modeling an offset of 40 basis points from tightening loan spreads and other factors.

An ~25% increase in the net interest margin over the next two years, combined with expected annual growth in core earning assets of 6%, will lift net interest revenue (which is approximately half of total revenue at JPM) at an annual rate of 15%+; there is a leveraged effect on earnings. We note that our 3.2% forecast for the core net interest margin in 2015 is below the 3.3% achieved in 2011 which was itself a 5-year+ low.

Exhibit 1: Past and Forward USD Interbank Rates

Source: Capital IQ, Bloomberg

The Loan, Deposit, and Asset-Liability Management Components of Net Interest Margin

On July 22nd, we made the case that, over the next two years, net interest margins for FDIC-reporting banks will increase to 4% from the current 3.2%. We noted that the current net interest margin is near multi-decade lows and the interest rate markets are beginning to price in some normalization of the yield curve with Libor expected to increase to 1.2% by mid-2015 (from the current 0.4%) and the 3-year swap rate expected to increase to 2.2% (from the current 0.8%). While there will be an important offset from tightening loan spreads, normalization of the yield curve will significantly impact growth since net interest income is approximately one half of overall bank revenues.

We also presented our framework, at industry-aggregate-level, for unbundling the bank net interest margins into components from the loan franchise, the deposit franchise, and asset-liability management (in turn comprising a “passive” component from the slope of the yield curve and an “active” component from, among other things, the investment securities portfolio and non-deposit liabilities including long-term debt). The framework showed that banks were making substantially all their net interest margin from their asset franchises and that recent margin-declines generated a meaningful headwind to growth. For example, in the first quarter:

  • An aggregate net interest margin of 3.4% (on a core basis to exclude the dilutive impact of trading portfolios) included a 2.8% contribution from the loan book and a 0.4% contribution from the investment securities portfolio – included as a component of the “active” ALM spread (see Exhibit 1). A positive margin contribution from non-interest bearing deposits was offset by a negative contribution from non-deposit interest-bearing liabilities so that the liability franchise made no net margin contribution. There was a slight positive contribution of 16 basis points from a positively-sloped yield curve.
  • Given difficult margin-compares, core net interest income declined 3% year-on-year despite 4% growth in core earning assets.

Exhibit 1: Aggregate Net Interest Margin Components for FDIC-Reporting US Commercial Banks – Earning Assets in $tn

Source: SNL, SSR Estimates

Unpacking the Net Interest Margin at JPM

This note begins our extension of the margin framework from the industry-aggregate level to individual banks, starting with JPM. Exhibit 2 shows JPM had similar margin composition (after allowing for the effects of JPM’s large trading book which significantly reduces reported margins) had similarities to the industry: the core (i.e. ex-trading) net interest margin of 2.8% in the first quarter was generated by a 2.2% contribution from the loan book, a 0.4% contribution from the investment securities portfolio, and 16 basis points from the slope of the curve; there was a small positive contributions from the deposit franchise, albeit with an offset from non-deposit liabilities (see Exhibit 2). Comparing JPM to the industry exhibit, we note:

  • JPM’s reported margins are understated versus the industry-average because of its substantial trading book accounting for approximately one-quarter of interest-earning assets; in Q2 2013, for example, the core (i.e. ex-trading) margin was 2.6% versus a reported 2.2%.
  • The aggregate yield at JPM is lower than the industry-average both because the bank has lower loan and securities yields, and because the balance sheet is more skewed to lower-yielding assets such as securities rather than loans; in Q2 2013, for example, loans were half of core earning assets at JPM versus an industry-average of nearly two-thirds.
  • As a partial offset to lower yields, JPM generates lower-cost deposit and non-deposit funding than the industry-average; in Q1 2013, for example, JPM’s rate of 28 basis points on interest-bearing deposits was approximately two-thirds the industry-average of 42 basis points. Furthermore non-interest bearing deposits account for a relatively larger portion of average funds: 26% in Q1 2013 versus 23% for the industry.

Exhibit 2: Net Interest Margin Components for JPM – Earning Assets in $bn

Source: SNL, Company Reports, SSR Estimates

Loan Yields at JPM Have Underperformed Industry…

While the industry model uses regulatory data (because it is more consistent across issuers and more granular including, in particular, a break out of the trading book), we can run a summary version of JPM model using GAAP, rather than regulatory, data and so update more quickly after an earnings release.

The Q2 2013 results indicate pressure on loan spreads so that the overall margin fell just over 20 basis points on a linked-quarter basis and more than double this year-on-year. As commented on the earnings call, the decline in the contribution from loan spreads was partly due to an adverse mix-shift[1] with deposits-at-banks (essentially cash and yielding a mere 34 basis points) increasing an extraordinary $100 billion+ in the quarter; this accounted for substantially all the growth in earning assets as management sought to accelerate compliance with regulatory requirements for the LCR (“liquidity coverage ratio”). However, it was also due to an outright decline in loan spreads as loan yields declined while the 3-year swap rate increased

As commented above, JPM’s loan spreads are now meaningfully below the industry-average. This has not been the case historically and, as recently as 2009, JPM’s loan yield exceeded, albeit not by much, the industry average of 5.6% (versus the Q1 results of 5% for the industry and 4.8% for JPM). The relatively low margin at JPM is surprising given the firm’s strong credit card business so that the proportion of the bank’s non-real estate loans to consumers stands at 23% versus an industry-average of 19% (see Exhibit 3).

Exhibit 3: Q1 2013 – Loan Composition as % Loans/Leases

Source: SNL, SSR Analysis. Loans include HFS and are gross of reserves, net of unearned income

… But Expect Relative Performance to Improve as New Mortgage Loans Exceed Legacy Run-Off

The relative decline in loan yields at JPM has coincided with a relative decline in the weighting of residential real estate loans in the overall portfolio. Exhibit 3 illustrates JPM’s underweight in mortgage and home equity lending which accounts for only 28% of its loan book versus 30% for the industry and higher for major competitors (as much as 44% for WFC). By contrast, in Q1 2009, JPM’s relative residential real-estate exposure was substantially above the industry-average and approached that of WFC (see Exhibit 4).

Going forward, we expect reduced pressure on the aggregate loan yield as JPM sees an improving environment for loan growth in general, and real estate loans in particular. On the earnings call, management commented that it added $5 billion of mortgage loans to the portfolio so that, even net of run-off from legacy portfolios, mortgage loans increased $1.3 billion quarter-on-quarter; in addition, management reported “very strong” growth in commercial real estate and pipeline improvements for C&I loans.

Exhibit 4: Q1 2009 – Loan Composition as % Loans/Leases

Source: SNL, SSR Analysis. Loans include HFS and are gross of reserves, net of unearned income

Valuation

Based on our valuation model (see Exhibit below), JPM is presently trading at a 20% discount to the price suggested by its tangible equity return on both an historic and prospective basis.

Valuation Exhibit

Source: SNL, SSR Analysis

APPENDIX:

Adjusting GAAP Margins for Tax Effects and the Trading Book

Like other banks, JPM presents net interest margin in a number of formats of which the most useful is the “core” result (see Exhibit A1) which excludes the impact of “market-based” activities i.e. of the trading book. Given the trading book accounts for ~25% of interest-earning assets at JPM, the adjustment to a core basis is significant and, indeed in 2013Q2, leads the core margin to be 2.6% versus the reported margin on a GAAP and fully-taxable equivalent or “FTE” basis of 2.2%. The two main adjustments from the GAAP presentation are:

  • FTE Adjustment: To the extent JPM invests in tax-exempt securities, or securities that receive tax credits, the net interest margin will be lower than had the investments been in economically-equivalent taxable securities (because such securities would generate higher yields), and income tax will be lower by the same amount. An FTE or “fully taxable equivalent” presentation puts taxable and tax-exempt securities on an equal footing by grossing up net interest income for the tax benefit of the latter. (Income tax is increased by an equal amount in an FTE presentation so there is no effect on net income).
  • Trading-Book Adjustment: Like other banks with market-based activities, JPM’s GAAP net interest margin is diluted down by the typically low net interest margin on trading account assets. In 2013Q2, for example, JPM’s trading book accounted for over one-quarter of interest-earning assets and generated a margin of just over 1% versus 2.6% for the non-trading assets. The “core” margin excludes the impact of these trading-related assets.

Exhibit A1:”Core” Net Interest Margin

Source: SNL, Company Reports, SSR Analysis

  1. As a reminder, the model calculates the contribution of loan spreads to the overall margin which are affected by both the outright loans spreads and the mix of loans in the overall earning asset portfolio
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