Wall Street returns to era of big profits

In dollar terms the biggest Wall Street banks are enjoying themselves more than at any time since 2007. After years of struggle, pre-crisis levels of profits are back.

JPMorgan Chase, Citigroup, Bank of America, Goldman Sachs and Morgan Stanley made a combined $17.6bn in second-quarter net income when they reported in the past 10 days. That is the best since the same period six years ago.

The new-found earnings strength has not gone unnoticed in Washington where Sherrod Brown, a Democratic senator, suggested to Ben Bernanke, chairman of the Federal Reserve, that he should not heed bankers' pleas to rein back regulatory pressure.

"It's no surprise that mega banks are doing quite well," he says. "Yet they continue to claim that regulations - new regulations, impending regulations - are killing them."

Investors have gravitated to a sector that not long ago used to struggle to attract interest as stormclouds from toxic assets to new regulations left banks unloved. Shares in BofA and Morgan Stanley have more than doubled in 12 months.

Yet these are not the same banks that entered the crisis. JPMorgan swallowed Bear Stearns and Washington Mutual, BofA bought Merrill Lynch and, even for those untransformed by mergers, there has been a monumental restructuring.

They have spent tens of billions of dollars on acquisitions, legal settlements and writedowns to return to those profit levels while, if you add back the failed or acquired Wall Street institutions, industry-wide profits are still down significantly.

And even if the headline numbers for the survivors look attractive, they are still far from pre-crisis levels of profitability. "You've seen this big rock - the regulatory change - splashing into the mill pond," says Brad Hintz, analyst at AllianceBernstein. "The thing it hits immediately is all the RoEs of the banks."

The average return on equity at the five big Wall Street institutions is 8.9 per cent, less than half the returns reached in 2006 and 2007, partly because regulators have demanded far higher capital levels to absorb future losses. But it is getting better.

"We are seeing slowly improving return expansion but also a growing divergence between the major banks such as Goldman Sachs and State Street that are several years into returning material amounts of capital compared to those banks that are just at the beginning of that process," says Howard Chen, analyst at Credit Suisse.

Revenues have been hit by the end of the mortgage refinancing boom that fuelled profits at banks such as JPMorgan. It has been all but extinguished on the back of higher rates, and though the housing market has stabilised it has yet to pick up sufficiently for new purchases to fill in the gap.

"All dressed up and nowhere to go," says Mike Mayo, analyst at CLSA. "Balance sheets are stronger, credits are better, capital is higher, risk is lower and that's all positive - on the other hand you're seeing pressure on revenues, margins and loans and that's a negative."

Mr Mayo points out that for all the signs of recovery, the ratio of loans to deposits is at its lowest level since 1984. This is in spite of the Fed's exceptionally low interest rate policies.

But optimists can counter most of the negatives. Marianne Lake, chief financial officer of JPMorgan, points out that even if they are not borrowing directly from banks, companies are able to tap bond markets for cheap credit at will, even after recent rate rises.

"Corporate America is very liquid right now and has access to the capital markets, which are wide open, so we're seeing that affect demand," she said after JPMorgan last week reported its highest ever half-year net income of more than $13bn.

If companies are flush with cash, consumers have also reduced debt, allowing banks to release billions of dollars of reserves set aside for bad debts.

"I think the consumer is doing well here and it's helping to keep improving credit quality in banks but more importantly keep the economy going," says Bill Demchak, who used to work on complex credit products at JPMorgan but now runs a more traditional bank, PNC Financial in Pittsburgh.

Goldman analysts pointed out on Friday that not only did 90 per cent of banks beat earnings estimates but 70 per cent also beat estimates on revenues: there are stirrings of life, it is not all cost cutting.

Most of them also managed to see off one of the most difficult challenges in the quarter: intense volatility in the bond market after comments from central bankers sent interest rates up. BofA was one of the few to suffer a decline in its fixed income trading business.

Morgan Stanley said that its bond traders had reduced risk during the period in response to violent market moves towards the end of May. "It was a tough quarter with the bond market in particular," says Ruth Porat, chief financial officer. "We did reduce risk in May given the volatility in the markets."

Executives, some of them wary of enticing regulators to go even further with tough new rules, are not celebrating too much even as investors show their enthusiasm. The industry has not yet proved that it can deliver the returns that it used to achieve when it was allowed to supercharge its business with much more debt.

Even the cautious, though, accept that US banks have achieved a platform for future growth. As Mr Mayo of CLSA puts it: "The engine's been repaired but they're still in first gear."

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