Two banking behemoths. Two different years. Two divergent equity returns. One common underlying reason.
There is no denying the fact that JP Morgan and Bank of America are in a league of their own. By their sheer size, scale and market dominance, they have a systemically important place in the financial system that is probably unparalleled in history.
Today we examine how their paths have differed over the past 3 years post the pandemic – all mostly attributable to one underlying reason.
First, here is a look at their comparative share price performance over 3 periods:
Full year 2021 – BAC : 48% , JPM : 26%
January through November 2022 – BAC : -18% , JPM : -16%
December 2022 till Oct 6 2023 – BAC : -29% , JPM : +5%
Borrow from Peter and Lend to Paul:
The business of banking, even though some folks might make it seem like fancy financial engineering, is a surprisingly simple one – Maturity Transformation. Borrow short and Lend long. And the summary in this case is that Bank of America decided to allocate a larger portion of their asset base to the “lend long” bucket than JP Morgan did. The result – JPM now has more flexibility to take advantage of increasing rates than it closest competitor BAC.
Lets dig a bit deeper.
BAC – Make hay while the sun shines
The first chart shows the trajectory of the two competitors’ asset deployment strategy over the past 5 years. BAC undertook a clear strategy to allocate a large percentage to investment securities compared to reserves (funds held at the Federal Reserve) and deposits at other banks. More specifically a larger chunk was allocated to Agency Mortgage backed Securities for the incremental spread over comparable maturity treasuries. It was good till it lasted in 2021 and BAC stock returns out-performed JPM by a mile. That was until the Fed embarked on the fastest rate hike in recent history. In simple terms, that means a larger portion of BAC balance sheet is locked up in these low yielding assets. Given the massive duration on these securities, any sales to free up balance sheet capacity entails crystallizing a significant loss.
JPM – Deposit taker of the last resort?
Second, and a bit surprisingly, BAC recent deposit trends look weaker than JPM. To comprehend the full landscape, one must understand that it is non-interest bearing deposits which matter most to a bank’s economic performance. A bank can mop up money with a high paying CD. But that’s hardly of any economic use in today’s rate and economic environment. While BAC is “home’ bank to many US blue chip corporations (OPAC liabilities) and a dominant retail franchise, the stark contrast to JPM in the loss of non-interest bearing deposits is unmistakable. Most of the drop in deposits for BAC seems to be attributable to its Consumer Banking and Wealth Management franchise. Conversely, deposits for JPM Consumer Banking and Wealth Management seem to be holding much better.
NIM-ble footed JPM
In summary, balance sheet flexibility due to a lower share of long duration fixed rate investments and the stronger deposit performance is enabling JPM to have a clear differentiation in Net Interest Margin and consequently Net Interest Income – a key driver of bank profitability.
Quarterly focus vs Long term strategy
The capitalist world can be unforgiving. For a period of time rates were very low in the immediate aftermath of a severe pandemic. Even the most distinguished of finance leaders were suggesting transitory inflation. After all we had lived through more than a decade of sub 2% inflation. It was in this environment that JPM still chose to take a different path than its closest competitor and hold more reserves at the Fed compared to investment securities. At every earnings release during 2021, JPM was asked the same question – why not sweat the asset book more by investing more in government treasuries and agency securities. Here’s an example below from the 3Q 2021 investor call. The pressure must have been intense all through 2021 and into 2022. But patience has its rewards – which are now manifesting in JPM stock returns in 2023.
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Hey, guys. Was hoping to follow up on the capacity to deploy liquidity. And I guess just to kind of lean in a little bit, if we look at the growth in deposits, I know some of them are kind of considered noncore, but take out the loan growth and the growth in securities book since COVID, you’ve got about an extra $500 billion of deposits. And how much of that do you think can be deployed into securities, and understanding that you expect loan growth to pick up so that will go to some, but is there a way to size that $500 billion capacity in terms of buying securities?
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Answer
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Yeah, so I think there’s a lot of factors that play into what the deployment decision is in any given moment. Obviously, as you said, loan growth, but also, we always make these decisions on the long-term economic basis, not for the purpose of generating short-term NII. And so when you do that, you have to think about capital volatility, drawdowns, and frankly, whether or not you see value. And that, if anything, is probably the biggest single factor right now.…So we’re always – we always try to be long-term economically motivated there considering all the scenarios, considering risk management, considering the convexity of the balance sheet, and looking at value and being tactical there. So that’s really how I would think about that.
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Who says Accountants are not Creative
Lastly, a short note on accounting jugglery as well. Investment securities generally are classified as Held to Maturity or Available for Sale. In the case of the former, the bank does not mark-to-market investment losses on the securities i.e. they are carried at amortized cost on the bank’s books. On the other hand, investment securities held in the Available for Sale book, need to be measured at fair value with any losses accounted for in the Bank’s Equity (via Other Comprehensive Income). It does not take a genius to figure that in an environment of steeply rising rates, it makes sense to transfer securities from Available for Sale to Held to Maturity, so that any further reductions in fair market value do not result in more hits to bank equity. The below paper at the University of Chicago suggests that cumulatively Banks in the US reclassified more than $900bn securities from AFS to HTM during 2022 (https://bfi.uchicago.edu/insight/research-summary/bank-fragility-and-reclassification-of-securities-into-htm/). It is difficult to pin point precise numbers since many Banks do not specifically disclose reclassification in quarterly results (I could find JPM disclosures on quantum of reclassified securities from AFS to HTM. But not for BAC). But the below graph does provide a representative (even though not comprehensive) idea of the difference in reclassification strategies adopted by BAC and JPM.
Earnings Yearnings
Bank earnings kick off next week. As of June 2023, BAC had gross unrealized losses of $105.7 billion on its Held to Maturity debt securities. Moreover, given the relatively benign or even favourable rates movement in the previous 3 quarters (4Q 2022, 1Q 2023 and 2Q 2023), the impact of mark-to-market losses on the AFS investment portfolio was benign (and mostly positive). The monster rates rally in Q3 2023 will have a negative impact on OCI and consequently Equity (that assumes no offset from derivatives).
Just to clarify, the above analysis does not infer that BAC is in any form of solvency risk. In fact, far from it. There would be hundreds of other banks which would face trouble before things get so bad as to merit a question over BAC. But it does explain a substantial portion of the divergence in stock returns over the past years!
Not meant to be Investment Advice. Do your own research. Happy investing!
Shashank Sawant
