The big banks won’t need overdraft protection to bail them out of their troubles in the energy sector.
On Wednesday, J.P. Morgan Chase announced that the bank increased its reserve for bad loans by $529 million in the first quarter of the year to account for potential troubles with its energy portfolio. That brought the bank’s total loan loss reserve to $1.3 billion. And while J.P. Morgan (JPM) was the first bank to report first quarter earnings, it won’t be alone in taking it’s lumps in the oil sector.
Wells Fargo, which reports its first quarter earnings on Thursday, has been a bit more aggressive extended credit to energy companies. In addition to the total $42 billion in direct loan exposure to energy companies, Wells (WFC) also made debt and equity investments in smaller energy companies with weak balance sheets and junk credit ratings. The investments, which originated at the firm’s Wells Fargo Energy Capital unit, totaled $2.1 billion in January 2014 and are currently believed to be worth around the same today, according to Reuters. The company has a $1.4 billion loan loss reserve right now, which is more than adequate to cover the Energy Capital unit, but doesn’t seem enough to cover it plus the $42 billion-worth of energy loans outstanding. As such, the bank will most probably end up reporting that it topped up its loan loss reserves in the first quarter, just like J.P. Morgan.
But while those two banks will be reporting higher loan losses as the “Shale Bust” continues, it won’t be anything they can’t handle. Unlike during the mortgage meltdown, the big banks seem to be doing a pretty good job this time around in setting aside sufficient capital to cover potential future losses.
In fact, it has been 18-months since the big collapse in oil prices, but still, no financial meltdown. Few would have thought that the energy and financial industries could have put off such a reckoning for this long. After all, when prices first started to come down, most analysts warned that if oil prices continued to weaken, the end was near. But as weeks turned into months and prices continued to fall with no disaster on the horizon, investors started to worry that the banks were somehow hiding their losses and covering for their clients.
To be sure, the final chapter of this story has yet to be written, but as of today, based on what we actually know, concerns of bank malfeasance in the energy space seem misplaced. And despite the increased risk associated with energy investments given today’s weak oil price, chances are, both J.P. Morgan, Wells Fargo and the other big banks will be fine, even if things spin out of control.
Take J.P. Morgan, for example. The investment bank, which lends heavily to the energy sector, came under scrutiny in the last few months amid concerns that it was failing to adequately account for the losses associated with loans it made to oil companies during the boom years. Jamie Dimon, J.P. Morgan’s chief executive, hit back, telling analysts at the bank’s investor day in February that the bulk of the bank’s energy lending was made to large investment-grade energy companies, the Oil Majors, like ExxonMobil (XOM), Shell (RDSA), BP, Chevron (CVX) and such, and not to the smaller subprime companies, many of which are now teetering on the brink of insolvency.
The bank has $44 billion in direct loan exposure to the energy sector, of which $19 billion is now considered to be below investment grade. But if it burns through all of the $529 million it just added to its loan loss reserves today, that would imply a loan loss rate of around 3% for its junk energy debt. While that might seem low, consider that even at the depths of the housing crisis, mortgage defaults never topped 3%. And investors seem to believe, the bank has done what it needs to do to protect it from further losses. Shares of J.P. Morgan rose on Wednesday following the announcement it was adding to its loan loss reserves, thought it was also buoyed by a small beat in the bank’s first quarter earnings. Dimon had promised to boost the loss reserves back in February, but investors, apparently, had to see it to believe it.
Things are a bit worse for Wells Fargo given its increased exposure to the energy space, but it probably won’t big a problem for the bank in the long haul, unless, of course, its bankers were really really reckless. While they may have been overeager, it’s hard to say they were reckless. The bank’s current $1.4 billion loan loss provision could absorb a nearly 75% loss in its Energy Capital Unit or a 3% loss in its overall energy loan book, both of which seem implausible given the bank’s usually strict lending standards. Nevertheless, given how badly some of its investments have performed so far, especially in its Energy Capital Unit, it wouldn’t to hurt boost its loan loss reserves, even if it is just to reassure investors that they have things under control. But given that Wells Fargo is one of the few big banks where revenue is still growing, it has some wiggle room to take the earnings hit of adding to its reserves.
To be sure, both banks will be feeling the burn from their energy investments, but given the state of the market, it’s just not hot enough to leave a mark.