• Wall Street’s biggest banks reported catastrophic first-quarter profit declines.
  • But Mohamed El-Erian says bank stock earnings haven’t been quite as ugly as you think.
  • In fact, the banks themselves may be deliberately making their results look worse than they really are.

The Dow Jones Industrial Average (DJIA) counts two financial institutions among its 30 blue-chip components: Goldman Sachs and JPMorgan Chase.

Both bank stocks reported first-quarter earnings this week, and the results weren’t pretty by any stretch of the imagination. But according to one economist, they’re a lot less ugly than either firm wants you to think.

Bank Stocks Hastily Build $20 Billion Loan Default Buffer

On Wednesday, Goldman Sachs reported a staggering 46% plunge in first-quarter profit. A day earlier, JPMorgan – the largest U.S. bank – told investors that profits had plummeted by 69% from the previous year.

It’s the same story outside the Dow Jones. Citigroup profit dove 46%, Bank of America’s slid 45%, and Wells Fargo reported net income of just one cent per share.

The coronavirus pandemic was the obvious catalyst for these earnings meltdowns, and each of these banks pointed to steep declines in lending revenue.

Widespread economic shutdowns have forced consumers and businesses to draw down on their credit lines and take out new debt. Lenders have warned that the long-term impact of the sudden stop in business activity could ignite a cascade of borrower defaults.

The default dominoes haven’t begun to fall – yet – but banks are funneling billions of dollars into their credit reserves in preparation for the looming tidal wave. Led by JPMorgan ($6.8 billion), the five largest U.S. banks collectively added more than $20 billion to their loan-loss buffers.

JPMorgan and other Wall Street banks are creating massive credit reserve buffers. And not just for the reason you think. | Source: Bloomberg

The clear implication from these results is that the banking sector fears a historic economic collapse. After all, the International Monetary Fund (IMF) just predicted that the global economy is facing its worst crisis since the Great Depression.

But economist Mohamed El-Erian says banks have a second motivation in adding to their credit reserves so aggressively. And it’s one that they’d prefer to keep a secret.

Banks Secretly Want You to Think Their Earnings Are Worse Than They Really Are

El-Erian, the chief economic advisor at Allianz and the former CEO of PIMCO, believes financial institutions want to distract the media from the enormous trading revenues they recorded during a ridiculously-volatile quarter for the stock and bond markets.

He told CNBC:

They expect, the IMF expects, everybody expects, the worst economic hit since the Great Depression. And that’s a big statement.

But I also think, if you’ve made a ton of money on trading, you really don’t want to show massive profits right here. You don’t want to say, “Hey look I’m doing OK,” while millions and millions of Americans have lost their jobs in recent weeks.

It’s not that banks don’t need to create loan-loss buffers. They’re absolutely going to face a substantial spike in defaults in the coming months.

But there’s a public relations incentive to inflate those reserves – and decrease your quarterly profits – beyond what you actually think is necessary.

Profiting from the Dow Jones Crash Creates an Optics Problem

Wells Fargo’s trading revenue declined during the first quarter, but the other four banks reveled in the increased trading activity that accompanied the Dow Jones Industrial Average’s quickest-ever descent from all-time highs into a bear market.

The Dow’s historic plunge – and subsequent recovery – has ignited a spike in trading revenue for Wall Street banks. | Source: Yahoo Finance

JPMorgan trading revenue surged 32% to a record $7.2 billion, and that wasn’t an outlier. Citigroup’s skyrocketed by 39%, as did revenue in Bank of America’s equities division.

Goldman Sachs was the relative laggard with an increase of “just” 28%.

Those results are a silver lining for shareholders, but they create an optics problem for a financial industry that may never recover from the stench of the Great Recession.

After receiving taxpayer bailouts during the last economic crisis, it’s a horrible look to appear to be profiting from the next one as it pushes American workers and small businesses to the brink of financial ruin.

Especially when you’re holding the debt that’s about to push them over the edge.

Disclaimer: The opinions in this article do not represent investment or trading advice from CCN.com

This article was edited by Sam Bourgi.

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