The second quarter for big banks: “It was probably as good an environment as you could have.” This quote comes from Carey Lathrop, co-head of global markets at Citi and a 32-year trading veteran, referring to what the financial institutions in the United States faced in the second quarter of 2020.

Second-quarter big bank profits were good, see here and here. The major reason for the “good” performance was trading profits.

Mr. Lathrop stated that there were two key factors to this performance. First, the clients of the banks were rapidly adjusting their portfolios to deal with all the fast-changing events taking place in the economy. Second, there was the massive bond-buying program of the Federal Reserve – and other central banks – and falling interest rates.

This Will Not Be Repeated

This environment is not going to take place again anytime soon.

Amrit Shahani, the research director at industry monitor Coalition, is quoted as saying that in the third and fourth quarters of this year, trading revenues will be at least 20 to 30 percent lower than in the second quarter. Volatility just cannot stay as high as it has been in the second quarter.

Yes, there are reasons for a continuation of market volatility. For example, the US presidential election might create an environment with high volatility, or tensions could increase between China and the US, or there could be a further jump in Covid-19 cases in US.

But volatility levels are not expected to be so high as focus is going to be directed elsewhere.

The Second Factor In Second-Quarter Bank Profits

The second major factor that impacted second-quarter bank profits was the increase banks made in their provisions for loan losses. The six major banks allocated more than $30 billion into their loan loss provision accounts and admitted that they had little or no idea of how much they would have to charge off in the future, so that allocations would be adjusted in the future as more and more information became available as to the new information.

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As Jamie Dimon, chief executive officer of JPMorgan Chase & Co. (NYSE:JPM), described the situation:

We don’t know what the future is going to hold. This is not a normal recession, and added that the bank was “prepared for the worst-case scenario”.

The Consumer Debt Situation

As reported in the New York Times:

“The United States went into the Great Lockdown with the most household debt in history, stagnant incomes for all but high earners and armies of people telling pollsters they were living paycheck to paycheck. Then, for millions, their paychecks stopped.”

But then the government stepped up, and personal bankruptcy filings actually fell off from April through June. The stimulus program of the federal government actually worked, allowing the unemployed not only to live and eat, but also to pay down existing debt.

This is not going to last and the banking industry is preparing for it. Efforts are underway to try and extend the government’s support, but it is expected that this will come to an end before the recovery gets too far along. Bankruptcies are a lagging indicator, but the economics of the situation finally come to dominate. And the commercial banks do not want to be caught short.

The Federal Reserve has produced information that show that 40 percent of the households earning less than $40,000 a year by the end of May had already lost at least one job. In those households earning between $40,000 and $100,000, 19 percent have lost at least one job. And for those earning above $100,000, 13 percent have lost at least one job. These are overwhelming statistics.

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Consumer bankruptcies are hanging over future bank performance and are going to accelerate in number.

The Commercial Debt Situation

I have already referred to the work of Edward Altman before. Mr. Altman is professor emeritus at NYU’s Stern School of Business and an expert on bankruptcy statistics. He is estimating that mega-bankruptcies will set a record in 2020.

More specifically, Mr. Altman is expecting that there will be at least 60 bankruptcies of organizations that are $1 billion or more in debt, and he is expecting over 190 firms with at least $100,000 billion debt to declare bankruptcy, falling a little behind 2009’s record of 242. (Note again that bankruptcies are a lagging indicator and 2009 was the third year of the Great Recession and 2020 is only the first year of this recession).

Mr. Altman believes that “the really hurting companies are too far gone to be saved.”

In terms of timing, Mr. Altman is expecting “a Covid-19 cliff” in the next 30 to 60 days.

The Future For The Biggest Banks

So, this is the reality of the situation that the big banks are facing. Loan write-offs, both consumer and commercial, are going to spike, and as of this date, there is really no way to understand how bad these charges are going to be. Most experts, as well as the banks themselves, expect that the amount will be substantial, and as Mr. Dimon stated, they are preparing for a worst-case scenario. We are now on the other side of debt levels being at historically high levels.

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Furthermore, investors should not expect the banks to be racking large profits from trading activities. The second quarter of 2020 was, as reported above, “as good an environment as you can have.” Exceptional trading results come and go and you cannot really predict them.

And we have only discussed the largest six banks in the country. What about the rest of the banking industry? I believe that the near future for them is more daunting than it is for the largest banks. As I have mentioned in earlier posts, expect the decline in the number of smaller banks in the industry to accelerate over the next two years or so. The domination of the larger banks is also going to accelerate, especially when you add into the equation the changing technology which will give the larger banks more scale efficiencies and greater network capabilities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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