5 Reasons Banks Are Profiting in a Recession

Investors and consumers are still reeling from the recession, but the nation’s big banks are posting huge, unexpected profits.

On Thursday, JPMorgan Chase (JPM) announced a $2.7 billion second-quarter profit. On Monday, Goldman Sachs (GS) announced a $3.4 billion profit for the same quarter.

What’s going on here?

Analysts say the banks’ results come down to two big common denominators: (1) investment banking, particularly an increase in underwriting activity (when companies turn to banks for cash), and (2) trading revenues from a volatile quarter that included a big rally.

About 80% of Goldman’s net revenues came from underwriting and trading revenues, says Scott Sprinzen, a managing director in the financial institution's ratings group at Standard & Poor’s.

Here are five reasons why banks are reporting big profits during the recession:

Companies looking to raise money or refinance their debt saw the second-quarter rally and the bump in optimism as a window of opportunity, and they brought their business to investment banks like Goldman Sachs and JPMorgan.

Separately, many financial companies were forced to raise additional capital during the second quarter. Banks and other lenders that accepted federal money under the Temporary Asset Relief Program (TARP) moved to return those funds to avoid additional oversight, but the government required that most of those firms raise additional capital before giving the money back. Those capital campaigns led to an increase in underwriting requests, particularly at Goldman and JPMorgan, Sprinzen says.

Here’s how underwriting works: companies approach Goldman or JPMorgan’s investing arm requesting cash. In turn, the banks talk to their clients (pension funds and insurance companies, for example) to see if there’s any interest among them in investing. Should the bank’s clients show interest, the company looking to raise money receives a check, and, in return, the bank collects an underwriting fee – usually a percentage of the amount the bank helped the company raise.

So far, second-quarter results show that banks recorded underwriting fees larger than those they earned during the tech bubble, says Michael Wong, an equity analyst at Morningstar. Because the stock market performed so poorly over the past year, there was a lot of pent-up demand during the second quarter from companies looking to raise money, he says. After the March stock market rally, companies took the opportunity to raise as much as they could – including not only the cash they need now but the cash that they anticipate they’ll need for the remainder of this year, he says. They took into account that investors may become skittish and less willing to lend later on, especially if the rebound slows down, he says.

Wong says these were extraordinary circumstances and that called this revenue stream from underwriting unsustainable. “[Since] equity underwriting demand was pulled forward from the future, that means there will be less demand to be fulfilled in the future,” he says.

Stock market volatility and the March rally triggered a flurry of trading activity earlier this year that contributed to banks revenues.

More people were trying to get in on the rally, buying or selling more frequently then they had in the previous quarter, says Jaime Peters, a senior equity analyst at Morningstar. Trading principal transactions brought in $3.1 billion in revenue for JPMorgan during the second quarter, she says.

The market’s volatility has played a significant role. “When things are more volatile, people tend to trade more, and as a result JPMorgan has more volume… which typically will result in more revenues,” she says.

Goldman Sachs and JPMorgan don’t trade on exchanges; most of their trades are over the counter, which means if you want to enter into a trade or a swap, you call the bank to arrange it and they make a commission on the deal.

Forecasts for trading remain mixed. “As credit continues to tighten we’re probably going to see trading income decline,” Peters says. “We’re at a high point with…the opportunity to make money in principal transactions, so it will come down.”

Richard Bove, a bank analyst with brokerage Rochdale Securities, says opportunities remain. The outlook for further gains in trading remains positive, especially in the category known as fixed income, currencies and commodities, Bove wrote in a report on Goldman’s earnings. “The mark downs and write-offs of the past year have ended to a great degree,” he writes.

The fact that fewer investment banks exist now than 18 months ago also plays an indirect role in Goldman and JPMorgan’s profits, Sprinzen says.

When companies want to raise money or conduct over-the-counter trading, they now have fewer places to turn. With Lehman Brothers and Bear Stearns no longer in business and Morgan Stanley turning more conservative in the business it takes on, Goldman and JPMorgan have reaped the benefits of a smaller playing field, Sprinzen says. That advantage should persist in the coming quarters.

Goldman and JPMorgan have another factor in common: neither are dealing with revenue-sapping toxic assets like mortgage-backed securities to the same extent as other banks, Sprinzen says. Freedom from those assets makes the banks less likely to devalue their portfolios down the road.

Goldman Sachs never had much exposure to these assets, and JPMorgan has sharply reduced its exposure, Sprinzen says.

“We don’t see potential for significant losses coming from write-downs of that type,” he says.

As for accounting tricks, Sprinzen says, “We don’t see that there’s anything going on here that would be cause for skepticism.”

On the consumer-banking side, all banks have been hit hard, but JPMorgan is in a better position than many of its peers like Bank of America (BAC) and Citigroup (C), Sprinzen says.

In the second quarter, JPMorgan made $15 million in retail banking services, down from $474 million in the first quarter, Peters says. Although those profits are comparatively small, retail banking could be a significant source of future gains, she says.

One reason is the historically-large spread in bank interest rates. With the Federal Reserve slashing the federal funds rate to 0.00% from 0.25%, banks now offer paltry interest rates for stashing your money with them. Meanwhile, with mortgage interest rates hovering around 6%, banks are making money off individuals who are approved for financing, while shelling out nearly nothing for savings.

Peters expects that this spread will continue until the economy shapes up. Once the unemployment rate slows its decline and the recession nears an end, more people will be able to get loans, and that will provide more huge profits to the banks, she says.