You would expect a very basic rule of the stock market to be that earnings are good. Yet this morning after two of the biggest banks in the nation Citigroup and Bank of America reported nearly $6 billion in earnings, not only did the shares of those two companies drop, but so did the whole market. The Dow Jones Industrial Average was down 200 points for much of the day.
It’s actually not that unusual for a company to report even rising profits and for its stock price to drop. How companies perform against expectations often matters more than actual results. Miss those expectations and you can expect a stock to drop. But that wasn’t the case here. Citigroup was expected to earn $0.05 a share. It ended up netting a nearly double $0.09 a share. Bank of America’s bottom line was nearly $1 billion more than expected. A number of executives have complained corporate America is being demonized for making money. Barbara Kiviat has correctly pointed out that this and other executive complaints are silly. Nonetheless, has Wall Street bought into the idea that profits are bad as well? Not quite. Here’s why:
The market’s negative reaction to Citi and B of A’s profits overlooked one very good, important piece of news. Both banks reported lower loan losses. That means their customers–credit card borrowers, homeowners with mortgages, businesses–had an easier time paying off their debts. For a market and an economy only a little more than a year out of the worst part of the credit crisis, this is really good news. Afterall, people defaulting on their home loans and other debts was how we got into this mess. News like this would have sent the stock market soaring a year ago. Here’s what an analyst had to say about that (via CNNMoney.com):
“In terms of credit quality, everything is moving in the right direction,” said Amanda Larsen, analyst at Raymond James, highlighting that reserves for credit losses fell to the lowest level since the third quarter of 2007 and delinquencies on Citi-branded cards also edged lower.
“The market has been freaking out about the health of the consumer as of late, and bank earnings are giving us solace that it’s not as bad as the market is making it out to be,” Larsen added.
However, a year later, the earnings boost that the banks got from fewer defaults is all of a sudden bad news. Here’s why: Even though the banks’ earnings were strong, revenue was lower than expected. Demand for new credit card loans, mortgages and business loans appears to be slowing. So how did the banks produce such good earnings in the second three months of 2010. It comes back to fewer defaults. When fewer loans go bad it’s doubly good news for bank profits. First of all a bank gets the loan revenue when a person or company makes their regular interest payment. Second, they don’t have to write off teh bad loan, which lowers earnings by itself.
Credit losses at Citi decreased by $422 million, which accounted for more than 20% of the bank’s quarterly earnings. At Bank of America, charge offs, or loans the bank doesn’t think it will collect on, fell by a whopping $1.2 billion, or more than a third of the company’s bottom line.
So are these earnings good news or bad news? To be sure, falling losses are what Wall Street would call lower quality earnings. Investors would like to see a company growing its business, not just saying the business it has is less bad. And investors are worried that bank profits will shrink once the benefit of not writing off bad loans disappears. But, to me, this is another sign that the economy is improving. And that should be good for the banks.
And while borrowing is down you would expect there to be a lull. Credit was very tight, which built up a pent-up demand for loans. Once the credit window opened earlier this year companies and individuals rushed to get in. Lending boomed. Now the lending business is either slowing or returning the pace it should be at this point in a recovery. If the later is the case, then today’s bad Wall Street news might actually be a sign of something pretty good.